Intel: A Moore Contrarian View

As the worst performer in the Dow Jones Industrial Average this year, Intel (Nasdaq: INTC  ) has been a stock worth ignoring. Yet now may be exactly the time for opportunistic investors to reacquaint themselves with the name.

After exiting the memory-chip business in 1984 to focus on microprocessors, Intel capitalized on the data-density law coined by its co-founder, Gordon Moore, to produce ever-more-powerful chips. By the summer of 2000, the company dominated the microprocessor market with its proprietary x86 chip architecture, boasted a $500-billion-plus market cap, and earned "gorilla" status from no less an authority than famed tech author Geoffrey Moore. Fast-forward six years to the summer of 2006, and the chip giant has seemingly lost its edge, suffering several notable technical and strategic missteps. Some might speculate that it is on its way to becoming the tech-stock equivalent of diminutive actor Dudley Moore.

How Intel lost its way
It doesn't take much detective work to shed light on why Intel's stock has languished for much of this decade. First, the PC market, the company's bread and butter, has matured. Meanwhile, cell phones and networked wireless devices - two markets Intel was slow to target -- have proliferated. Finally, in the lucrative market for high-end corporate servers, a fixation on clock speeds was trumped by chief foe AMD's (NYSE: AMD  ) focus on performance, size, and energy-efficiency advantages.

A spate of less-than-ideal news has also weighed on Intel shares this year. Among the headlines:

  • AMD is suing the company for unfair competitive practices.
  • Intel has lost its exclusive hold on marquee customer Dell (Nasdaq: DELL  ) .
  • Management markedly lowered 2006 guidance because of excessive inventory levels at its key customers.
  • In order to reduce inventory levels of last-generation products, the company appeared to launch a price war against AMD.
  • Microsoft (Nasdaq: MSFT  ) has delayed the launch of its Vista operating system (a critical catalyst for PC and microprocessor purchases) into 2007.

Have we reached bottom?
Despite its travails, Intel's stock may now be signaling that a bargain is at hand. For those who place faith in the notion of reversion to the mean -- a concept underscored on The Motley Fool's BMW Method board -- Intel now trades more than two relative mean squares (akin to standard deviations) below its mean 20-year stock price trend line. In plain English, this means the company's stock is currently trading at an unusually depressed level that may not persist.

In order for Intel to be a true bargain at current prices, however, investors must believe that the company's recent hangover is temporary in nature, and that lost ground can be recovered. Its financial history might provide the basis for such optimism. An examination of metrics based on unlevered free cash flow (operating cash flow less after-tax net interest income, capital expenditures, and tax benefit from options) illustrates this point. We use unlevered free cash flow in this exercise because we want to hone in on the true cash flow power from the company's operations before any financing decisions.

Cash flow tells an interesting story
Intel's median unlevered free cash flow margin (unlevered free cash flow divided by total sales) from 1995-2005 was 19%. Its median CROIC, or cash return on invested capital, was 28%. CROIC is similar to return on invested capital, or ROIC, except that unlevered free cash flow replaces net income in the numerator and net cash is subtracted from the denominator. Both the former metric, which captures the attractiveness of the company's profit structure in cash terms, and the latter, which measures management efficiency, are very good.

Yet for the first six months of fiscal 2006, both of those metrics had fallen to zero, suggesting a fundamental deterioration in the business. All else being equal, we might infer the worst. But Intel's financial past reveals an interesting insight: Neither the unlevered free cash flow margin nor CROIC have been uniformly consistent over the past 10 years. The company posted an unlevered free cash flow margin and CROIC as low as -2% in 1995 and 3% in 2001. Yet in each of these instances, a dramatic rebound to more impressive levels was achieved within two years. Why? Because the company used its formidable resources to reestablish a product technology advantage and secured a manufacturing cost advantage.

A familiar formula for redemption
What might give investors comfort that Intel can repeat past redemption today? Aside from its formidable brand name, new products, perhaps. The company is introducing several new 64-bit dual-core processors (Woodcrest, Conroe, Merom) for the server, desktop, and notebook markets, the latter being a category where Intel has dominant share. Based on benchmark tests versus AMD's Athlon processor, these new Core Duo products boast dramatic improvements in performance and energy efficiency. Apple's (Nasdaq: AAPL  ) decision to switch from IBM (NYSE: IBM  ) to Intel chips may add credence to Intel's technology renaissance. More recently, the company secured another key victory when Sprint Nextel (NYSE: S  ) committed to spending $3 billion to build a network based on the WiMax wireless technology standard championed by Intel and others. Sprint's decision potentially gives Intel a beachhead position in a lucrative emerging market.

In addition to new product developments, Intel is attempting to refashion itself as a leaner and meaner operation by:

  • Aggressively ramping up production at new 65-nanometer wafer fabs in an effort to establish new cost advantages
  • Undertaking layoffs to protect profitability
  • Divesting the rights to the underperforming XScale cellular business for $600 million
  • Seeking to divest other underperforming businesses, such as the communications processor line

More to consider
Today, investors may want to consider some appealing (and perhaps surprising) attributes of Intel:

  • It sports a dividend yield of more than 2.1% (17% higher than the yield of the S&P 500).
  • Its diluted share count has fallen nearly 16% since 2000 (the result of numerous out-of-the-money options expiring unexercised, and management's commitment to share repurchases).
  • On an enterprise value basis, Intel trades at less than 13 times the unlevered free cash flows earned in its most recent fiscal year. (On a trailing 12-month basis, Intel trades at a more expensive 21 times.)

Only time will tell what will happen to Intel. Will it recapture investors' hearts like a one-time Hollywood starlet who emerges from a long absence as fetching as before (think Demi Moore)? Or will it fade into obscurity like a former prime-time sweetheart from a now-bygone era (think Mary Tyler Moore)?

Moore Intel Foolishness:

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Fool contributorVik Murthyand his wife own shares of Intel and Microsoft, which are bothInside Valueselections. Dell has been chosen by both Inside Value andMotley Fool Stock Advisor. The Fool has adisclosure policy.


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