It's that time of year again. The time when we all sit back, quaff a few root beers, stuff our turkeys, and suffer through Aunt Helen's psychopathic babble about how when she was a young girl they didn't have turkeys. They had spam and were thankful for it! It's Thanksgiving and it's a reminder to count our blessings for those of us who abstain from any regular tallying. So, what is there to be thankful for in Rule Maker Land? Well, Intel (Nasdaq: INTC) for one. Intel has been one of the stocks in the portfolio that's performed fairly well. The real question is whether or not we'll continue to be thankful in the future.
A few weeks ago, we did a quick Ben Graham equation calculation on the stocks in the Maker portfolio and Intel came out of that simplistic ritual as one of the more overvalued stocks in the portfolio. Let's look closely at Intel through the Rule Maker lens to see if it still holds water on our criteria.
1. At least one sustainable competitive advantage -- and the more, the better.
When it comes to being the big dawg in the yard, Intel is the biggest dawg of all in the semiconductor business. For over 30 years it has built a business focused on having the most cutting edge processors on the market. The great majority of the time, it has the best-performing chip out there. But, even when a competitor like Advanced Micro Devices (NYSE: AMD) comes along and challenges Intel's technical superiority, Intel is able to convince most of the world, through branding and technical trickery, that they are still the best choice. Why else would Gateway abandon AMD for Intel when AMD produces theoretically superior chips at a lower price? Probably because customers were confused and wanted Intel Inside. Does Intel have a sustainable competitive advantage? I think they have several. Yes.
2. Great management of unquestionable integrity and with a track record of excellence.
Intel's past and present management is top notch. Andy Grove is one of the most respected CEO's ever and his successor, Craig Barrett, is excellent as well. Though coming under fire for his diversification strategy, Barrett has a solid vision for where he wants to take the company. In a recent interview, Barrett shoots straight about all of the critics. Right now, he's exercising some of Intel's real options and we'll have to be patient to see where it leads them. The company is straightforward and investor friendly. Yes.
3. Expanding possibilities that will allow the company to have a future that's sweeter than the present.
The core microprocessor business, the Pentium 4, is solid and growing. This is an established business and not something I would generically lump into the "expanding possibilities" category other than to say that as processors become more advanced, the world will continue to find more uses for the power, and it'll open new doors that we're likely not thinking about now. Their expanding possibilities are in the networking communications, wireless communications, and servers that Barrett talks about in the article mentioned above. The programs have been slow to take off given the ugly market for tech, but all seem like natural extensions of the business. Time, and a more robust environment for capital expenditures, will tell the tale of Intel's expanding possibilities. Probably, but we'll wait and see.
4. Annual sales growth of at least 10%.
There's no doubt that Intel's sales growth is slowing. This is likely to be the first year of negative revenue growth in the past 10 years. That shows you how steep the decline has been, or perhaps how crazy the tech spend was in fiscal '99 and '00. While this year will be negative, the company has a pretty consistent record of 10% or higher sales growth. I'm cautiously optimistic that they can continue at this pace, and 2002 comparisons will likely be great compared to this year. Still, the current environment presents a red flag to keep an eye on. Generally yes, recently no.
5. Gross margins greater than 50%.
In past years, gross margins have consistently exceeded 50%. In fact, the last full fiscal year where gross margins didn't exceed 50% was 1991. The past few quarters, however, have seen a pretty drastic drop in margins, and this isn't one we should take lightly. This past quarter, gross margins were 46%, down from an exceptional 64% in the same quarter last year. Intel says this is due to weak demand for processors, and higher start-up costs in their wireless and architecture groups. Intel forecast 47% gross margins for their fourth quarter. This is close to 50%, but the drastic drop and the uncertain nature of their start-up businesses makes this a tad worrisome. No.
6. Net profit margin of at least 10%
Another item that falls into the "generally yes, but currently no" category. Net margins for Intel's business have been dropping these past three quarters from 7%, down to 3%, and only 1.6% in the September quarter. A 25% decline in the microprocessor business is a major culprit, and you have to believe that any rebound in the market for their products will result in a sharp increase in net margins. Given their past record of generally blowing the 10% number out of the water, I'm fairly confident they can achieve this again. Probably, but not currently.
7. Cash King Margin greater than 10%.
Intel's free cash flow to sales ratio, even in this pitiful environment, was around 10.6% this past quarter. Last year, it was 18.2%. The company has done a good job in the past of managing its free cash flow, and this may be an even more important measure than net margins, so we have some solace here, even with recent weak demand for the core product. Yes.
8. Cash no less than 1.5 times total debt.
Cash and equivalents are about $4.8 billion and total debt is just about $1.3 billion. Yes.
9. Efficient working capital management, as measured by a Foolish Flow Ratio no greater than 1.25.
Intel's Flow Ratio is 2.03 for the most recent quarter. No.
10. A reasonable purchase price that allows for the clear possibility of 2x/5y.
This is the hardest one, of course. If Intel were to double in 5 years, its valuation would be about $400 billion. Processor speeds will be around 20 gigahertz for their microprocessors if Moore's Law stays intact. What will that mean for revenue and the bottom line? Tough to tell, especially with no real idea of how strong their new business will be. Let's be generous and assume 10-15% revenue growth for 5 years, and also 10% growth in free cash flow. That will put them around $12-$15 billion in free cash flow with a $400 billion valuation. That's 26-33 times trailing free cash flow. Unheard of, no. Even at current prices, shares are trading at around 34 times trailing free cash flow. I think it's possible for Intel to double in 5 years if everything goes exceptionally well. There's not a lot of margin for safety here though. The tech market has to turn, the other businesses have to pick up, and they must continue to fend off the competition. Maybe.
Conclusion:
A tough year has put Intel on the ropes with the Maker criteria in a way we've never seen been before. Is this just a deep cyclical downturn that will change course quickly or is it more telling of the future for its business? Everything I see points to a rebound in the core businesses and the possibility that Intel will achieve great results. At $30 a share though, it's no slam dunk to be a double in five years. I hate to be wishy-washy, but I'm really on the fence about Intel. What do you think? Let us know on the Rule Maker Strategy board.
Have a wonderful Thanksgiving holiday and we'll see you all next week!
