Intel Again
Bull Argument
By
Brian Lund (TMF Tardior)
Intel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %> has been one of the most innovative and profitable companies in the 20th century. Its management, sales, and marketing teams -- not to mention its research and development -- have made it the King of Microprocessors ever since Intel invented the darn thing in 1971. It has so dominated the industry that it is able to maintain profit margins in excess of 25%, despite operating in a commodity industry. Intel is becoming more than just the Processor Potentate, however. As it expands into network and wireless communication equipment, it positions itself to profit in higher-growth industries.
The power of the Intel processor
Intel bears dwell on the fact that Intel has lost the high-end processor lead to Advanced Micro Devices <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AMD)") else Response.Write("(NYSE: AMD)") end if %>, whose Athlon has bested the Pentium III. Citing the delays in its next-generation 820 chipset a year ago and its subsequent recall, bears say that Intel hasn't displayed processor innovation for some time. These things are true. Intel has trailed AMD in innovation over the last year.
But, has it really hurt Intel? Here's an article discussing AMD's Athlon chip at its release, and the implications for Intel. Notice the date on the article -- August 12, 1999, more than one year ago. So, Intel has lost market share, right? Er, no. One year ago, Intel had more than 80% of the microprocessor market. Today it has -- drum roll please -- more than 80%. AMD has apparently taken market share from Cyrix and IDT, but not Intel. After 20 years of competing with AMD, despite fears and changes in technology, Intel still dominates the microprocessor market.
Surely the Athlon and its accompanying price pressures have been disastrous for Intel's margins, right? Again, no. In the third quarter of 1999, its gross margins were 58.7% and after-tax operating margins were 21.1%. In Q3 of 2000, they were 63.9% and 24.7%, respectively. Those are Intel's highest gross margins in years, despite trailing AMD in the high-end processor race.
AMD may be coming on strong -- and more power to it -- but it hasn't hurt Intel yet. Gross margins will decrease slightly in the near future because of the costs associated with the 1.4 GHz Pentium 4 production ramp-up, but that product will also keep Intel on top.
Processor sales still growing
Your Intel bear may also say that the processor business is pass�, that it can't muster the kind of growth rate that the market has priced into Intel. He may also suggest that the recent enormous increase in chip production capacity at Intel and AMD will cause a supply glut. I don't agree with either of those claims.
As Business Week reports, "More than 350 million computers were sold last year, and that number should increase at least 20% in 2000, according to projections from technology consulting outfit Gartner Group. If that growth holds up, it will soak up the excess production coming from both chipmakers' new plants." Then there's the high-growth server market, where Intel has grabbed significant market share with the Xeon chipset, a high-margin product.
The notion of "dumbing down" the PC has been way overdone, too. I can't imagine that networking will allow us all to have basic, "dumb terminals" at our desks. One of the happiest days in my life was the day that the Fool replaced the Pentium II 266 MHz I used to work on with my current Pentium III 600 MHz. Even on a network, the power of the end computer will always be essential to maximize performance.
Expanding into new businesses
Even in the eventuality of zero growth in the processor market, however, Intel can do just fine. It has begun to diversify its revenue stream into networking and communications products -- and it has often become the leader in its area. Through the acquisition of Level One Communications in 1999, Intel increased its market share in the Local Area Network Application-Specific Standard Product segment from 21.8% in 1998 to 34.5% in 1999. Number-two vendor Lucent Technologies <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: LU)") else Response.Write("(NYSE: LU)") end if %>, meanwhile, dropped from 20.5% to 18.9%.
Intel has also made huge strides in wireless communication. It is the world's largest manufacturer of flash memory, which is essentially the random access memory (RAM) in digital cellular phones, digital cameras, LAN switches, PC cards for notebook computers, and other devices. Through its 1999 acquisition of DSP Communications, Intel is seeking to enter the logic or chipset side -- the processor -- of mobile devices.
In this area, Intel recently introduced its new XScale architecture. The beauty of XScale is that its power can be adjusted, running from 200 MHz on 1/20 of a watt, to 800 MHZ on just under a watt, according to the desired power capability, so that battery life can be preserved. Immediately after the XScale was unveiled at the Intel Developer Forum in August, rumor spread that Palm <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PALM)") else Response.Write("(Nasdaq: PALM)") end if %> would use XScale in future generations of its PalmPilot.
Revenue growth and diversification
The long and short of it is that Intel has an unbelievably strong core business in microprocessors, where it dominates its industry as much as one company legally can. Intel is not resting on that business, however. The revenue mix is shifting rapidly from all-architecture (processors and motherboards) to other products. Take a look at this table of Intel's revenue:
Q3-00 Q2-00 Q1-00 Q4-99 Q3-99
Arch.($mil) 7038 6759 6609 6955 6268
Other ($mil) 1693 1541 1412 1257 1060
Total Rev Growth 19% 23% 13% 8% 9%
Arch Growth 12% 22% 3% 0% 1%
Other Growth 60% 30% 109% 94% 113%
Arch % of Rev 81% 81% 82% 85% 86%
While growth in the architecture segment has slowed, the "other" category, which is mostly revenue from network and communication groups, has grown significantly. The revenue mix has shifted from 86% architecture a year ago to 81% in the latest quarter.
Future growth
Intel expects the architecture segment to grow about 10% annually over the next five years, while "other" growth should approach 50%. Let's extrapolate trailing-12-month revenue (as of Q3) at those rates:
2001 2002 2003 2004 2005
Arch ($mil) 30097 33107 36417 40059 44065
Other ($mil) 8855 13282 19922 29884 44826
Total ($mil) 38952 46388 56340 69943 88891
Growth 17% 19% 21% 24% 27%
Arch % of Rev 74% 71% 65% 57% 50%
Two important things come out here. First, the architecture segment diminishes rapidly in importance. Second, the total revenue growth rate is huge for a company this size. In this scenario, Intel still qualifies as a growth company, even at its current market cap.
Think those projections are too aggressive? Let's cut the growth rates in half, to 5%, for the architecture group, and 25% for other businesses:
2001 2002 2003 2004 2005
Arch ($mil) 28729 30166 31674 33257 34920
Other ($mil) 7379 9223 11529 14411 18015
Total ($mil) 36108 39389 43203 47669 52935
Growth 14% 9% 10% 10% 11%
Arch % of Rev 80% 77% 73% 70% 66%
Even in this less-optimistic scenario, double-digit growth continues and the architecture segment grows less important. Keep in mind, too, that this is just revenue growth -- Intel also has $14 billion in cash and $6.3 billion in long-term investments that are kicking off a decent chunk of cash every quarter. This level of income growth can support Intel's expected 20% long-term growth rate.
As of last week, Intel was going for about 29 times trailing free cash flow and 22 times 2001 estimates. It has a current P/E of 26. Shares in this longtime world-beater are quite affordable.
Intel still sits atop its core business. At the same time, it is expanding into related, higher-growth businesses. Its aggressive diversification effort benefits mightily from its cash horde. That cash is meaningless without know-how, of course. Fortunately, Intel has know-how in spades. It has one of the most forward-looking, intelligent management teams in the business. It also has a fantastic sales and marketing team (the blue guys in green paint notwithstanding). That is the foundation on which Intel will build its current and future business, and it's rock-solid.
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