Investment Thesis

Intel (INTC) looks cheaply valued on the surface at just 11x this year’s free cash flow.

But peeling back this free cash flow, and considering its operating leverage, as well as, its growth prospects, I contend that this stock is actually more expensive than it first appears. Investors would do well to avoid this name for now and look to reenter at a lower price point.

Revenue Growth Rates Lose Steam

Previously, I had been bullish on Intel, although I’ve never held any position.

Truthfully, I consistently inform my Deep Value Returns Marketplace members that it’s bad practice to sell into bad news on the back of an earnings report. Having said that, on this occasion, there’s very little here that makes it worthwhile holding onto whilst Intel is still traded with a $200 billion market cap.

Source: author’s calculations, **company guidance

It’s not only the fact that guidance for Q4 2020 is pointing towards a negative 14% y/y. Accordingly, Intel’s poor near-term prospects go beyond this next quarter.

Firstly, it appears that looking ahead, into next year, analysts don’t expect much improvement.

Source: SA Premium Tools

Even though I don’t put too much weight into analysts’ estimates, these estimates are negative enough to highlight that Intel has hit a rough patch, out of which it doesn’t appear to be coming out of any time soon.

Secondly, it’s Intel’s Data-centric business that suffered the most in Q3 — the area in which Intel has over the past few years been attempting to pivot towards:

Source: Q3 2020 Press Statement

Indeed, we can see that Intel’s Data Center Group (”DCG”), as well as, its memory business (NSG) which performed the worst during Q3 2020.

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What’s more, ironically, Intel’s legacy PC-centric business (”CCG”) business which performed the best, and was up 1% y/y, driven by notebook sales during COVID.

Obviously, the work-from-home and study-from-home trend benefitted here, but while this uplift was unexpected, investors shouldn’t count on a repeat performance to this segment in the quarters ahead.

Importantly, investors had been expecting Intel’s data-centric business to be picking up positive momentum by now, whereas quite the opposite dynamic is taking place.

Balance Sheet Less Strong Than Desirable

Moving on, arguably, the most critical aspect for investors to bear in mind is that Intel’s business model carries a substantial amount of operating leverage. This implies, that as long as Intel’s top-line is growing, its margins expand, and Intel’s ability to be a strong cash flow generating machine works positively.

However, as Intel’s revenues contract, the opposite drive takes place; and its profit margins compress. To illustrate, back in Q4 2019 as its top-line grew by 8% y/y, its operating margins reached 35.7% (non-GAAP).

However, looking ahead to Q4 2020, as its top-line is expected to compress by 14%, its operating margin now points 31.5% (non-GAAP) — approximately 420 basis point compression. Why is this such a problem?

Because this impacts Intel’s ability to generate strong and sustainable free cash flow. Even if 2020 is pointing $18.5 billion of free cash flow, approximately $1.5 billion improvements from last year, this level of free cash flow is unlikely to be sustainable, as Intel’s top-line weighs down, and its margins compress.

Furthermore, the only reason why Intel was able to uplift its EPS guidance into Q4 2020 is due to its accelerated stock repurchase program.

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However, given that Intel has a net debt balance sheet of $18 billion, Intel’s ability to be a strong repurchaser of its own shares is likely to slow down.

Valuation — Not Enough Upside Potential

The issue with Intel is that its valuation presently stands in no man’s land. It’s not cheap enough for value investors to get involved, and it’s not growing its operations strongly enough for growth investors to get involved.

Indeed, the main reason why Intel had been given the benefit of the doubt this past couple of years (at least by me), had been because its attempt to pivot away from its reliance on its legacy PC-centric business was gathering steam.

However, management now declares that its cloud business will undergo a period of digestion and Q4 2020 is expected to be down 25% y/y.

This is sort of narrative, backed by tangible figures, is hardly commensurate with that of a strong and stable semi business.

Admittedly, at the most superficial level, paying less than 11x free cash flow for a household semi company is not expensive — or so it seems.

Having said that, as I’ve argued throughout, Intel’s operations carry a significant amount of negative operating leverage. Consequently, despite having made more than $15 billion in free cash flow during its trailing 9 months, thereby averaging out close to $5 billion of free cash flow per 90 day period during 2020, as we look ahead, Intel’s free cash flow will drop back to close to $3 billion of free cash flow in Q4 2020.

Once again, this $3 billion of free cash flow in Q4 2020 pales in comparison with the $5.2 billion Intel generating in Q4 2019 — minus 42% y/y.

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The Bottom Line

The main theme I’ve contended throughout is that Intel’s strong growth narrative, that of pivoting away from its reliance on its PC-centric business appears to be losing steam.

Furthermore, even if investors proclaim that paying less than 11x free cash flow is a rewarding opportunity, I assert that investors should look beyond that way of thinking.

As Intel starts lapping its performance from last year’s Q4 2019, its operating margins and free cash flow will look unappetizing, and investors are likely to see this stock sell-off further.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.