Intel (INTC) and Mobileye(MBLY)

A week ago, INTC agreed to buy MBLY, an Israeli company that makes cameras and car safety devices, for $15.3 billion in cash.  Its plan is to merge its existing auto components business with MBLY and have that company spearhead INTC’s entire Internet-of-Things effort to enter the auto market.

Why buy rather than build?

The main issue is time, I think.  Part of this is that the timetable for development of autonomous driving vehicles is accelerating.  More than that, however, and the chief reason for the acquisition, to my mind, is the way marketing to the big auto companies works.

Auto companies plan new models several years in advance.  If you want a component in, say, a 2020 model, you probably need to have already convinced an auto maker of its merits by late last year.  Also, unless a component maker has a unique technology, auto companies tend to move slowly.  They’ll initially buy a single component, or they’ll put a part in one car model, just to see how the part–and the supplier–perform.  If things work smoothly, it will consider expanding that part’s use and/or buying other parts from the supplier.

The result is that convincing a car company to risk of using a new supplier takes a long time.  Without MBLY, which already makes key auto components and has an auto-oriented sales force, I think it could easily be a half-decade before INTC would make any significant inroads into the auto market.  INTC probably doesn’t have that much time.

This is not, of course, to say that INTC will be wildly successful in the auto-related IoT.  Without MBLY, though, its chances for success would be considerably dimmer.

3Q16 earnings for Intel (INTC): implications

Last night after the close, INTC reported 3Q16 earnings results.

The number were good.  INTC’s growth businesses grew; its legacy arms showed unusual pep.  The latter development had been flagged by INTC during the quarter when the company announced wholesale customers were increasing their chip inventories. Nevertheless, earnings per share of $.80 exceeded the average of 29 Wall Street analysts by $.07–and surpassed even the highest street estimate by a penny.

Despite this, the stock fell by about 3% as soon as the earnings release was made public.  Traders clipped another 2% off the share price on the earnings conference call.  During trading today, the stock initially fell almost another 2%, before rallying a bit to close just below its worst aftermarket level.

There was some bad news in the report.  It will cost INTC more than anticipated to rid itself of McAfee.  It also looks like chip customers are no longer so eager to build inventory.  Instead, thus far in the fourth quarter they seem to be subtracting some of the extra they added during 3Q.   The result of this is that INTC thinks 4Q–usually the strongest period of the year seasonally–will only be flat with the robust performance of 3Q16.

 

I find the selling to be unusually harsh (be aware:  I own INTC shares).  After all, if INTC had earned the $.73/share the market had expected, a forecast of $.76 wouldn’t look all that bad.  That outcome, which appears to be the company’s current guidance, would also be better than the analyst consensus had been predicting for 4Q last week.

I’m not trying to argue that the stock should have gone up on this report.  I just don’t see enough bad–or, better said, enough unforeseeably bad–news to warrant a selloff of this magnitude in a gently rising market.

I attribute the aftermarket selloff to some combination of computer trading and thin volumes.  What surprises me is that there were no significant buyers once regular trading–overseen, presumably, by senior human investors–began.

Because of this, I think that trading in INTC over the next days is well worth watching to see if/when buyers reenter the market.  We may be able to draw conclusions that reach wider than INTC itself.

Intel (INTC) and ARM Holdings (ARMH)

At its Developer Forum yesterday, INTC announced that it is opening its cutting-edge fabs to manufacture chips that employ ARMH designs created by third parties.  So, as at least part of its business, INTC intends to become a foundry like TSMC.

(An aside: despite its glitzy style, it’s much harder to find information about the move on INTC’s website than on ARMH’s.  I don’t know whether this has any significance, but it’s the sort of odd fact that rattles around in a security analyst’s head until an answer can be found.  Is it me?  Is INTC more interested in sizzle than steak?  Is INTC’s IR effort still mired in the mindset of the former regime?…)

I’m not sure what the total significance of this move is, but at the very least:

–TSMC, the premier foundry, a Taiwanese company, trades at about a 17x price earnings multiple.  INTC now trades at about the same PE, although it has typically traded at a lower rating than TSMC in the past.  In contrast, ARMH trades at about 70x, a PE that I think must be unsustainably high, even though ARMH has managed to do so for years.

For my money, INTC’s fabs are better than TSMC’s.  Making loads of ARM chips for others will likely not lower INTC’s pe ratio.  Arguably, as the foundry business expands, INTC’s pe will rise.

–in every generation, the size of chips shrinks while the cost of a next generation fab rises. As a result, the amount of output that a fab must have to be able to operate profitably increases, while the penalty for having too little output goes up as well.

The ARMH partnership signals, I think, that INTC believes that to maintain its manufacturing edge, it must accept manufacturing orders from outside parties.

 

More tomorrow.

 

 

 

 

Intel’s restructuring announcement yesterday

Yesterday, Intel (INTC) announced 1Q16 earnings that were up year on year and more or less in line with the Wall Street consensus.  It did, however, lower full-year 2016 guidance a bit, based on a weaker than anticipated PC market.

More important, the company also disclosed a major restructuring aimed at orienting INTC away from its legacy personal computer business and toward the cloud.  The restructuring will eliminate about 12,000 jobs, or 11% of INTC’s workforce.  It will result in a $1.2 billion charge against 2Q16 earnings and is intended to be saving $1.4 billion annually a year from now.

The plan appears to be at least in part the brainchild of Venkata Renduchintala, recently hired away from Qualcomm to be INTC’s president–with the intention of having him make the kind of changes just announced.

Reading between the lines, this is a good news – bad news story.  The good news is that INTC, seeing the Ghost of Christmas Future in Hewlett Packard, is making significant changes to reorient its business.

The bad news is that it sounds to me like there may be a significant anti-change bureaucracy entrenched at INTC.  This is what I read the Oregonian as saying when it cites “a lack of product/customer focus in execution” as Mr. Renduchintala’s conclusion from his review of INTC’s manufacturing operations.  That’s also the reason, I think, for changes in senior management.  Maybe a fat-cat attitude is not so odd for big corporations in general,  but it’s of disappointing for a firm whose former chairman and manufacturing chief wrote a management book twenty years ago titled Only the Paranoid Survive, stressing market awareness as key to success.

In practical terms, I think what this means is that INTC is still a bit more GM-ish than I had thought possible. In consequence, the transformation INTC has been talking about for years and which current top management clearly wants won’t take place overnight. Still, I think that the moves INTC is making are needed and are an overall plus.

Pre-market reaction has been mildly negative.  I guess that’s about what one should expect.  Personally, I’m encouraged and remain content to collect the dividend and wait.  I’d be tempted to buy more on a selloff.

4Q15 for Intel (INTC)

After the close last Thursday, INTC reported results for 4Q15 and the full year.  For the final three months of last year, INTC posted revenue of $14.9 billion, operating income of $4.3 billion, net of $3.6 billion and eps of $.74–all better than the Wall Street analyst consensus. The company also announced an 8% increase in the dividend, to a yearly total of $1.04.

Nevertheless, in Friday trading the stock was down by 9.1%.

What’s going on?

There are lots of moving parts, but in a nutshell INTC appears to be forecasting another flattish eps year for 2016–vs. market (and my) expectations of a return to earnings growth.

The main reason is softness in demand that INTC is already experiencing in its important Asian markets, particularly in China.  My back of the envelope calculation is that pre-tax income for INTC will still be up by about 15% this year, despite a China slowdown.  But I think the shift of business growth from Asia to the US + the EU is the main reason the company is projecting a rise in its income tax rate from 19.6% in 2015 to around 25% this year.  That’s enough to wipe out virtually all the pre-tax improvement in the business.  So the bottom line remains basically unchanged.

Another worry:  during 4Q15 revenue from INTC’s important server business decelerated from a 10%+ growth rate to just over 5%.   Operating income fell by about 4% yoy, as high margin cloud sales cooled while low margin networking sales boomed.  INTC points out that 4Q14 was a record quarter, so simple yoy comparisons may be misleading.  It also says that the fourth quarter has become important enough for online sales that cloud customers don’t want to fool with their websites by installing new equipment.  So for its most important class of customers, 4Q is no longer the seasonal peak for orders, as it has been in prior years.

Two oddities:

–for reporting to shareholders (financial accounting)  INTC is changing the way it expenses the chip manufacturing equipment it uses.  It previously wrote their cost off in equal installments over four years.  It’s now going to use five.

Nothing changes in the way the business is being run or in the way the equipment is written off for income tax purposes.  But annual depreciation cost on the income statement will be about $1.5 billion less than under the old method.  In broad terms, this is enough to offset the rise in the tax rate for 2016.  It’s also the largest factor involved in my thinking pre-tax income will rise significantly in 2016.

It’s hard to know whether Wall Street will regard this accounting change as a good thing of a sign of weakness.  I presume algorithmic traders won’t care.

–for the past couple of years, INTC has tried to buy its way into the tablet business by essentially paying customers to use its chips (the company calls this support contra revenue).  The company appears to have pared back the subsidies significantly during 4Q15.  Tablet units decreased from 12 million in 4Q14 to 9 million in 4Q15, as a result.  But overall tablet revenues increased.–and operating losses in the segment appear to have shrunk.

My bottom line:

For the moment, I’m content to hold the stock.  There’s enough evidence from other hardware companies to suggest that the Asian slowdown is an industry phenomenon, not an INTC specific one.

We’ll also know in a quarter or so whether the cloud business bounces back or not.  Given the significant shift in retail from bricks and mortar to online this holiday season, I’d expect to see strength in cloud orders during 1Q16.

Finally, I’m a bit troubled about the change in depreciation policy.  The effect is to make earnings look better than they would otherwise be.  Is that the purpose, though?  Was INTC forced to do so by its auditors, or is this simply optics (which would be a very bad thing, in my view)?  I’m not sure.

merger mania in the computer chip business: why?

This year has been market by a spate (like that word?) of mergers/acquisitions in the computer chip industry, the latest being the potential combination of stodgy Analog Devices with Maxim Integrated Products.   Why is this happening now?

Three reasons:

–cheap financing, even though not necessary in all cases, is still plentiful.  This may not continue to be the case as interest rates in the US rise

–the cost of creating and fabricating new generations of products is becoming very expensive, to the point that some firms can no longer afford to stay independent and remain in the game

most important, though, is the emergence of mega-customers like Apple and Samsung, or Acer and maybe even Asus, which has changed the competitive structure of the industry.  The situation now is that these few large buyers of components can play one supplier off against another to get better prices.  The only way suppliers can get any market clout is to combine.

 

One might think that this is evidence of the overall tech industry maturing, meaning that we’re entering a period of slower industry growth.  While that may be true, maturity isn’t the sole, or even the main, reason for consolidation.  When the EU was created, for example, cross-border mergers became feasible for the first time.  Small national supermarket chains combined to become EU-wide powerhouses.  For a while, food suppliers remained as small as before.  But the mammoth size of EU-wide purchase orders from the big supermarket chains became so enticing that food suppliers offered unusually high discounts to get the business.  These firms soon realized that they needed scale, both just to get the big supermarket orders and fulfill them and to streamline operations and lessen profit-destroying discounting.  The large scale of the customers forced the suppliers to scale up as well.

The economics works in the other direction, too.  Large scale on the suppliers’ part forces customers to scale up.

In the case of chip companies, I don’t see an easy way to make money right away from ongoing consolidation.  Many of the actors remain unattractive on a stand-alone basis, in my view.  Also, the general rule is that half of the combinations won’t work out, either because the principals can’t get along post-merger or an acquirer pays too much for a target.  Better to let the dust clear and try to assess the combined firms, say, next Spring.  Having said that, I do own Intel and Avago, two consolidators.

Avago (AVGO) and Broadcom (BRCM) …and Intel/Altera

Two days ago the rumor hit Wall Street that chipmaker and serial acquirer AVGO had found its newest target, BRCM.  Yesterday the offer was announced:  cash and AVGO stock, in approximately 45/55 proportions, totaling $37 billion.

my thoughts

When customers in a given industry group become bigger and more powerful, the natural response among suppliers is to do the same.  This is part of what is going on here.  More than that, AVGO appears to seek out companies whose technological virtuosity far outstrips their management skills.  So it gains not only the marketing benefit of size but also the rewards of improving the profitability of firms whose main virtue has been their intellectual property.

What’s striking about this deal is that in revenue terms AVGO is more than doubling its size.  Although I have no intention of selling the AVGO shares I own, experience says that acquirers often bite off more than they can chew when they make the jump from small acquisitions to super-size ones like this.

One of AVGO’s rumored other targets had been Xilinx (XLNX), the junior partner with Altera (ALTR) in the field programmable gate array duopoly.  I had thought that ALTR would feel more favorably disposed to overtures being made by Intel (INTC), given the possibility that AVGO would buy XLNX and turn the firm into a much more aggressive competitor.  That threat is now gone.  INTC must now rely on pressure on ALTR management from its major shareholders (shareholders are, after all, legally the owners of ALTR and the employers of management) to return to the negotiating table.

As a practical matter, managements have a lot of autonomy, despite the fact that we the shareholders are, technically speaking, the bosses.  Wall Street seems to believe that ALTR is holding out for a higher price from INTC.  While that may be the rhetoric being used, I think the real issue is more basic.  Who would want to go from being the master of all he surveys as the top dog (and treated as a demigod) at a major publicly traded company to being a near-invisible division head in a conglomerate?