I think there's plenty of upside to chipmaker Intel's (Nasdaq: INTC) microprocessor business.
If you look at the PC industry, we're in the teeth of a recession. In fact, market research firm IDC estimates that U.S. PC shipments will decline in 2001 -- for the first time ever. IDC expects a 6.3% decline in the U.S. this year, compared to worldwide growth of 12.9%. All told, overall PC growth is expected to come in around 5.8% this year, way down from 15.6% growth in 2000. Here's a look at IDC's projections for growth in worldwide PC shipments:
Year % growth 2001 5.8% 2002 12.2% 2003 14.3% 2004 10.7% 2005 9.3% Source: IDCThese forecasts, of course, are estimates. Nevertheless, the trend makes sense. PC growth rates are certainly slowing, but what we're seeing this year, as Intel Chairman Andy Grove described in a recent interview, is a cyclical slowdown, not the death of the PC era. The markets will stabilize and grow again.
Intel continues to lead the world in the production of microprocessors. It has the largest market share, the highest margins, the most efficient systems (even in a dreadful year such as 2001, gross margins are expected to land in the 50% range), and financial strength that's allowing it to invest more than $6 billion in capital expenditures this year to upgrade its facilities. Its competitors simply don't have the financial muscle to match this investment, which is being used to move its fabs to the 0.13 micron-technology, and 300-millimeter wafer technology. These larger wafers, for example, are expected to reduce die manufacturing costs by 30%. Investors therefore will likely see a solid payoff on Intel's current capital expenditures.
If Intel failed to expand into any new areas, the company estimates it could maintain revenue growth rates in the 10% range. Frankly, given the profitability of its microprocessor technology, this would be satisfactory for the Rule Maker. Looking back at the company's operating income growth, free cash flow growth, and cash flow from operations growth of the last five years, Intel has performed better than some have reckoned. (Numbers in millions of dollars.)
Year Op. income FCF CFO PP&E* 2000 $10,395 5,266 12,827 6,674 1999 9,767 8,225 12,134 3,403 1998 8,379 5,475 9,447 3,557 1997 9,887 5,283 10,008 4,501 1996 7,553 5,523 8,743 3,024 1995 5,252 350 4,016 3,550Here's what I see: Intel reported a five-year average annual operating income growth rate of 14.63%. Add back hefty amortization charges in 2000 and it has grown even faster. Free cash flow growth may not look as though it has grown, but in fact the company is generating enough cash from its business to roughly double capital spending without significantly lowering free cash flow in 2000 relative to 1996.
*property, plant and equipment spending
The microprocessor business is a cash cow for Intel, and will continue to be so, though growth rates will certainly slow. At the same time, Intel won't be needing to spend between $6 billion and $7 billion annually to upgrade its facilities. As capital expenditures moderate, Intel will produce more cash.
Of course, management is not happy living in the world of microprocessors with the grass growing slower, so it has branched into other areas. Specifically, Intel now has five operating units: the Intel Architecture Group, the Wireless Communications and Computing Group, the Network Communications Group, the Communications Products Group, and the New Business Group.
This is where investors are looking at a sea change. Throughout the 1990s Intel focused on manufacturing microprocessors, which still account for 80% of its revenues. Intel pretty much set the pace of microprocessor change, so even though it had to deal with rapidly advancing technology, this risk was somewhat mitigated by the company's dominance. Traditionally, one of the most attractive aspects of Intel's business was that it was easy to understand: The company makes microprocessors, the brains in your desktop, workstation, and laptop computer.
Its new focus is much more varied and much more difficult to understand. In presentations, Intel has failed, at least in my mind, to clearly express its new direction in understandable terms. Yes, we know the company wants to provide a new generation of silicon infrastructure. We know it wants to provide networking and communications tools. We know it wants to provide higher-end server products to support the build out of tomorrow's new networked age. But it's hard to know what this means.
It may be that the vision is still crystallizing, or that it's just plain hard to grasp. But so far the company has provided little in the way of concrete detail to help investors understand what this means beyond a few numbers.
For example, in 2000, the Intel Architecture Group -- the company's core microprocessor business --generated $27.3 billion in sales and $13 billion in profits. All the other units, which include the company's new initiatives, provided $6.4 billion in revenues and reported an operating loss of $2.6 billion. Revenues from new operations grew 64% last year, and Intel expects to see growth in the 50% range for these divisions for some time. Despite growing operating losses in these units, therefore, the company is gaining traction, it seems, in its new ventures, even though it's difficult for investors to see Intel's path.
If anyone can make this transition, it's Andy Grove and CEO Craig Barrett. Given Intel's management strength and position in the lucrative microprocessor business, it remains a good long-term bet for the Rule Maker Portfolio. But as an investor, I'm discounting the fact that Intel is a tougher company to understand than it used to be. The fact that management now must be focused on much more than just microprocessors is significant, particularly for investors trying to understand Intel's direction and predict its future cash flows. I won't be as willing to pay as high a multiple for its earnings as I might have been in the past.
I'm in favor of keeping the company in the portfolio; I think it will weather the storm. But I get a little nervous with it representing as much of our portfolio as it does, and I'd like to see us be very selective in terms of adding new dollars to our position.
Note: The Rule Maker managers have decided not to invest this month's $500 installment in a company, but to keep the cash in a money market account and wait for a better opportunity. We'll also continue our search for new Rule Maker candidates.
Have a great day.
Richard McCaffery, Rule Maker co-manager, doesn't own shares of Intel. The Motley Fool is investors writing for investors.