Intel's structural business model transition
The bear call on Intel Corporation (NASDAQ:INTC) is not "PCs stink, short the stock." Rather, we believe Intel is undergoing the beginnings of a structural business model transition that carries significant risk.
Intel Corporation (NASDAQ:INTC)'s market is shifting away from high-ASP, high profit dollar parts as the market transitions to lower end offerings. Pricing in the core business is at risk as Intel attempts to drive volumes through mainstream price points. We see mix-related pricing as a headwind in 2014.
New Atom offerings are no longer "crippled" but bring increased risk of cannibalization and structural underutilization.
The company is preparing for a huge investment to "buy" their way into the tablet market, with goals to increase tablet shipments by 4x (to ~40M units) in 2014 leading to substantially increased losses in the Other IA segment.
Finally, Intel Corporation (NASDAQ:INTC)'s process advantage may not necessarily translate to product dominance.
Data Center cannot fill slipping margins
Data Center is a fantastic business, but you can't fill a fab with it.
Intel Corporation (NASDAQ:INTC) ships ~300M PC MPUs per year, Data Center volumes are barely 5% of this. As a result, Data Center margins have been slipping, and have not kept track with Intel's "50% operating margin" targets.
They have little share left to take in traditional markets as Advanced Micro Devices, Inc. (NYSE:AMD) is now approaching irrelevancy, and new entrants are coming up from below.
Finally, Intel's Data Center 2014 guidance of up in the low to mid double digits (with their long-term 15% target unchanged), requires a substantial enterprise recovery (up 8%).
Intel's foundry policy seems weak
We do not expect Intel's new foundry policy of "willing to talk to all" will have any material impact in 2014 or in the near future.
Intel's current "high value, low volume" foundry efforts likely have excellent economics but are inherently limited; low volumes are a blessing (no need to build capacity) and a curse (we will never see it in the numbers).
A move to high volume leading edge foundry (e.g. mobile SoCs) would bring substantial business and strategic risks given Intel Corporation (NASDAQ:INTC) is attempting to build a own business here. Plus, Intel would need to build capacity, pressuring ROIC and increasing the company's capital intensity.
As suggested by comments at the CES 2014, while Intel Corporation (NASDAQ:INTC)'s willingness to "hold conversations with anyone" on foundry is a big change from yesteryear, it does not appear to us that Intel is throwing open the fab doors on foundry efforts. Overall, we do not expect Intel's foundry efforts to have a material impact in 2014 or in the next few years.
Pressure on free cash flow
Pressure on free cash flow implies that cash return MUST slow, and the stock is no longer "cheap" vs. the large-cap tech universe. We do not believe cash return is enough of a reason, in and of itself, to buy the stock.
Capex has doubled, capital intensity is at historical highs, and FCF/revenue is approaching 10 year lows, limiting Intel's headroom to grow cash return. The current dividend is on its 6th quarter (the first time except for the crisis years that Intel has gone more than four quarters without raising it), and buybacks have materially slowed.
Stagnating earnings and free cash flow have, in our opinion, removed the valuation argument as well; the stock is no longer "cheap" vs. the universe of large-cap technology. We believe investors will see slower rates of cash return growth going forward.
PC data points lead to better stock performance
We note some potential for upside risk in the near term from "less bad" PC data points. However, we believe it would take a sustained PC recovery to derail the structural short thesis; PCs simply becoming "less bad" do not, in our mind, invalidate the structural short.
Intel Corporation (NASDAQ:INTC) stock has done well recently likely due to PC data points becoming "less bad" as YoY PC shipments declines have slowed (e.g. the classic semiconductor "second derivative" story), and investors have begun to wonder about the prospect for some near-term upside as Intel gets ready to report earnings this week.
That being said, our thesis is structural in nature. While a sustained PC recovery could conceivably derail the bear thesis, PCs simply getting "less bad" is not nearly enough, in our opinion, to invalidate the structural case against owning Intel. As we move through the year, we continue to expect risk from mix-related pricing issues and continued increased investments to pressure the stock.
Overall, we do not believe the company is doing anything wrong. But, the path they are on, even if by necessity, is likely to be painful for investors. As we have said repeatedly, we don't want to be along for the ride.