[Editor's note: The follow article was revised on July 25, 2001 due to an error in the cash conversion cycle calculation. The chart has been updated and the opinion has been slightly altered.]
Spring has come and gone, but it's never a bad time for cleaning. So, over the next few months, the Rule Maker Portfolio will be reviewing its current holdings one at a time. Today, we start with our biggest holding, Intel (Nasdaq: INTC).
Currently Intel comprises a little more than 15% of the Rule Maker Portfolio, and judging from the numbers below, I couldn't be happier.
Last Qtr Last 12 Mos Sales Growth (16.5%) 7.0% Gross Margins 51.7% 59.7% Net Margins 7.3% 24.7% Cash-to-Debt Ratio 8.5 11.7 Flow Ratio 1.26 0.98 Cash King Margin (22.2%) 6.0%
I know. You're thinking I picked the wrong week to stop sniffing glue. But even though the trend line for every financial measure is in the wrong direction and some fail to live up to our stringent criteria, Intel remains profitable and cash-rich. As I wrote last month, Intel is currently scraping its knuckles on the bottom of the semiconductor cycle and still remains a profitable and healthy company.
Sales growth is dismal, but we've seen this before. In fact, this is the pattern with Intel. In Q2 1998, revenue growth was negative, gross margins dropped to 48.9%, the Cash King Margin was negative, and net margins were way off their highs. That happened to be the bottom of the last semiconductor cycle and here we are again. Surprise, surprise, surprise! Intel is in a cyclical business and the investors with linear extrapolitis can only see red. Those who understand the nature of the industry and Intel's place in it can rest easy. We see the trees through the forest.
For the 12-month period following Intel's slide that ended in Q2 1998, it posted revenue growth of 14.7% and free cash flow growth of 145.9%. Gross margins improved 240 basis points and the same short-term investors that bid the share price down jumped back on the Intel bandwagon and drove the price up.
A few numbers that have concerned me for some time are the days sales outstanding (DSO) and days inventory outstanding (DIO). These numbers have been trending up and we want them as low as possible. A low DSO means Intel is collecting its receivables quickly and a low DIO means there is less risk of inventory write-offs. (See this article for a more in depth explanation.)
Q101 Q400 Q300 Q200 Q100 Q499 Q399 DSO 51.0 45.0 45.9 43.4 41.5 39.4 41.5 DIO 68.3 58.2 50.6 43.1 45.4 44.0 50.4 DPO 66.4 56.5 61.9 51.1 47.1 41.6 43.4 CCC 52.9 46.7 34.7 35.4 39.8 41.8 48.5
DPO = days payable outstanding
CCC = cash conversion cycle
The CCC measures the number of days it takes a company to purchase raw material, convert it into a finished good, sell the finished good, and collect payment on that product. Intel's CCC is not trending in a good direction and it appears that Intel is unable to control this cycle any better than the next guy. Days sales outstanding is not far from its normal range, but inventory is spending nearly twice as many days in the warehouse as it was just a year ago. Even though Intel has countered this by paying a little slower than normal, the sequential percentage changes are worrisome.
Up to now, Intel has avoided a catastrophic inventory write-down like that of Cisco (Nasdaq: CSCO), but just like Cisco's networking products, Intel's microprocessors have short lives. Who wants a Pentium II in their new computer? Intel is dropping prices to counter this inventory buildup and although Craig Barrett, Intel's president and CEO told us that during Q2 the "microprocessor business performed better than expected, with sequential growth in units," it's the communications and flash businesses that remain a concern. Fortunately, Intel still derives 80% of its revenues and all of its profits from microprocessors, motherboards and board-level products, rather than the struggling communications products.
That said, Intel has seen cash conversion cycles (CCC) in the mid 50s before. In fact, Intel's CCC used to linger in the 50 to 60 day range. We'll be watching close to see if Intel can push its cash conversion cycle back down to the 30s when the semiconductor cycle turns up.
How did we react in early 1998 when Intel was bottoming? That's when we started buying Intel and for a while there it looked like we were master investors. (For a while there, it looked like everybody was a master investor!) Yet, as Rich pointed out in a recent column, Intel has changed quite a bit since then, so we need to revisit why we invested in the first place.
Intel was the dominant player in the chip market. Check. Intel's products were going to play a significant role in the world over the next five years. Check. Intel was highly profitable. Check. All these characteristics still exist and I'd argue that its dominance is only enhanced by the hazy forecast. Competitors like Motorola (NYSE: MOT), AMD (NYSE: AMD), and Texas Instruments (NYSE: TXN) also have to figure out how to navigate the unexplored seas ahead. Intel's balance sheet gives it a leg up on the competition in times like these.
The balance sheet shows $10 billion in cash and another $2.3 billion in long-term investments. Sure, that's down from $11 billion in cash and $9.8 billion in long-term investments a year ago, but much of that money was spent on capital expenditures. Plus, the move to 0.13-micron technology and 300-millimeter wafer technology is expected to save billions. Intel is gearing up for its future as a manufacturer of all kinds -- networking, communications, and PC -- of chips. Management has proved that it can be the most efficient producer of microprocessors on the planet. Now it must translate that to other types of chips and chipsets.
Debt is a paltry $1.2 billion. However small, this amount has always bothered me. Why would a company with so much cash take on any debt? Well, digging into the 10-K, we see that the nearly $400 million represents non-interest bearing "drafts payable" and the majority of the rest ($600 million) was incurred in connection with the construction of a manufacturing plant in Ireland. Interest is payable in Irish punt and hedged to limit interest-rate risk, so that's reassuring. I can only assume that the political goodwill Intel is earning far outweighs the economic cost.
Over the last decade or so, the Irish government has been pushing its lush green countryside as a tech manufacturing haven. Motorola, Intel, Compaq (NYSE: CPQ) and Dell (Nasdaq: DELL) are some of the largest employers in Ireland. The Emerald Isle has even been jokingly referred to as the 51st U.S. state. So, when the Irish government offers you low-interest financing, you take it and get on with business. The amount is nominal to Intel and based on the $738 million in average long-term interest-bearing debt during calendar 2000 and an interest expense of $35 million for the year, Intel's average interest expense was 4.7%. That's less than what it's earning on its invested cash. This is an example of positive leverage.
If we expected our companies to continually improve margins and never allowed for market corrections, we wouldn't need such tough criteria. We'd need a crystal ball. The reason I'm so pleased with Intel is precisely because it's flexing its financial muscle and it appears the years of disciplined conditioning are paying off.
I'll touch on Intel's valuation next week. Remember, it's important to account for the cyclical nature of a company like Intel when estimating its future cash flow.
Todd Lebor is a co-manager for the Rule Maker portfolio and lives in Alexandria, VA. At the time of publication, he owned shares of Intel. Todd's other holdings can be found online along with the Fool's complete disclosure policy.