Following Intel's (NASDAQ: INTC ) recent investor meeting, shares of the chip giant sank as guidance for a flat 2014 disappointed analysts and investors. High capital expenditures and a declining PC market are largely to blame, with investments made over the past few years having yet to pay off. But, there's more to Intel's presentation than lackluster guidance.
Intel is still a cash cow
Even as Intel struggles to gain a foothold in the rapidly growing mobile market, the company still has two divisions that generate significant cash. The PC client group, responsible for the traditional PC market, generates around $33 billion of revenue per year, converting $11.6 billion into operating profit. This operating margin of 35% shows that, even as the PC market declines, Intel's dominance allows it to maintain exceptional profitability.
Intel believes the PC market is stabilizing and that units will fall only slightly next year. Revenue from the group is expected to fall by mid-single digits, but operating profit should be roughly flat. This is better guidance than expected, and Intel's ability to maintain its margins on PC processors is a big plus.
The other division that generates plenty of cash for Intel is the data center group. This group is responsible for server and workstation markets, where Intel is king. The group generates $11.5 billion of annual revenue, with an operating margin of 47%. What's more, Intel projects revenue to grow by 15% per year in the long term, and expects operating margin to grow even faster.
Intel owns approximately 90% of the server market, dwarfing competitor AMD (NASDAQ: AMD ) . But, AMD, which makes chips based on the same x86 architecture used by Intel, announced last year that it would be bringing chips to the market based on the ARM architecture, developed by ARM Holdings (NASDAQ: ARMH ) .
One large barrier to entry for any ARM-based server chip is the large market share enjoyed by Microsoft's Windows Server, which runs on the majority of servers and requires an x86 processor. While the growth of the cloud certainly changes the dynamics of the industry, I don't see x86 being supplanted by ARM any time soon.
The data center group is a huge growth driver for Intel going forward, and it should help balance the impact of a declining PC market. The company is also expanding into related areas, like high performance computing. While Intel sells the Xeon Phi, an add-on accelerator card, the next version will give Intel a huge edge. Due in 2015, the next version of the Phi will be able to serve as the sole processor in a system, a big advantage over solutions from rival NVIDIA.
A big tablet push
Intel's other architecture group generates $4 billion in revenue per year, with an operating loss of about $2.5 billion. This group is responsible for mobile processors, and Intel has made little progress gaining market share in this area. But, Intel is projecting it's tablet volume to quadruple in 2014 compared to 2013, enabled by its low-power Atom processors.
This would result in significant share gains, but this progress comes at a cost. Intel is projecting revenue for the group to be flat, meaning that it's likely offering big discounts to OEMs on its Atom chips. One report suggests that Intel plans to offer $1 billion in subsidies to tablet vendors next year, and that Intel is also providing its mobile communication chips for free to help OEMs lower the cost of bringing Intel-powered tablets to the market.
Intel's market share is currently minuscule compared to ARM, and it's clear that the company is trying to make up for lost time. But, with the high spending needed to gain market share, it's unclear whether or not Intel's return on investment will be attractive. Analysts at RBC Capital downgraded the stock after the presentation, citing exactly these concerns.
Dividend growth will likely slow
While Intel has grown its dividend rapidly over the past decade, it looks to be inevitable that this growth will slow down considerably. Intel targets a free cash flow payout ratio around 40%, which is roughly where it stands today. With operating income set to remain flat next year, there may not be another serious dividend increase until 2015, assuming that the mobile business starts to turn a profit by then.
Intel's first capital allocation priority is to invest in the business. It's clear from the doubling of capital expenditures compared to 2010 that Intel is staying true to this idea, which means that dividend increases take a back seat to capital investments. With a 3.8% dividend yield, Intel already pays one of the highest dividends compared to other big tech companies, so slow short-term dividend growth shouldn't be a big concern for dividend investors. But, the lack of meaningful dividend growth could keep some investors away.
The bottom line
Intel is being dragged down by a declining PC market and an unprofitable mobile business, and its big bet on tablets is costing the company billions of dollars. These are good reasons to be concerned, but Intel has the potential to grab a significant share of the mobile market from ARM in the coming years. Combine this with a highly profitable and fast growing data center business, and the long-term picture for Intel looks promising.
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