Seventy-four percent.
That, according to Standard & Poor's, is how much Intel's (Nasdaq: INTC) 2001 reported earnings would be reduced, if stock options were accounted as an expense. That's an enormous amount for a big company that, frankly, doesn't grow like it once did. Check that. It's a huge amount for any company. Flip it over, and it seems worse -- Intel's earnings are overstated by almost 300%. Yowza.
Intel's earnings multiple would be unbelievably high as a result of these economic adjustments. The company's 2001 earnings would've been reduced from $1.29 billion to $334 million. At today's market capitalization of $124 billion, that translates into an adjusted P/E of 371. Even using non-core, GAAP earnings, Intel sports a P/E (using current, not 2001 earnings) above 65. This for a company with essentially flat sales in 2001, from its sales five years previous. This from a company that's exhausted many of its best margin-generating markets. Intel doesn't have a sufficient margin of safety at these price levels. And given its opposition to stock option accounting, I don't want to believe it.
Ah, but that's emotional. We shouldn't allow our emotions to rule our investing decisions. At the same time, investors must have highly attuned self-preservation instincts. These will, of course, let us down from time to time, but sometimes when the hair on the back of your neck stands up, it means danger. We can elect to fight or flight, and with member companies of the American Electronics Association (AeA), I've elected to do both.
I'll tell you this: Andy Grove, a key architect of Intel's spectacular growth story, remains a hero of mine. The culture he helped inspire at Intel is one of the true engines behind the resurgence of the American economy. But I have no confidence that the markets Intel attacked and controlled in the past will be more than slow growers in the future. And its biggest growth drivers now -- video gaming, wireless communications, and high-end servers -- don't strike me as world-beaters or low-hanging fruit. The past pattern of continually releasing faster, higher-margin processors every 18 months or so has been broken. And if the independent benchmarkers are to be believed, AMD's (NYSE: AMD) mid- and low-end processors give Intel's a run for their money. Such issues indicate this isn't a low-risk situation for my money. Furthermore, I haven't a clue how to evaluate the technology itself. So we're getting out.
Intel's core business is faltering
Once upon a time, you could count on certain things. Autumn was the opening of football season; Barron's would call the market overvalued; Dennis Rodman would have a new hair color; and Intel would launch a new category-breaker technology, starting a whole round of hardware upgrades.
Something has happened, though. In the last year or so, the consumer and non-tech business departments seem satisfied with the amount of speed offered by their current processors and aren't upgrading. Seriously, who needs 2Ghz to browse the Internet? So while computers through the early 1990s offered a performance deficit, because they were consistently trumped by speed-hog applications, that's no longer the case. As such, upgrade cycles among many computer markets are lengthening. Moreover, the overall price for such models has continued to drop, carving ever deeper into margins. This is a bad thing for Intel.
Intel is spending in an effort to position itself for an eventual economic rebound, as evidenced by its enormous commitment to Prescott, the next Pentium 4 launch due out next year. Intel hopes the markets are skipping a round of upgrades as capital spending is reined in, but that they'll jump back on the train when things loosen up. This is a time-tested strategy of the strongest -- spend while times are bad, leaving your competitors to play catch-up. But what happens if the rapid sales cycle has suddenly outgrown itself? Intel has pressed into the communications market, wireless, and servers, but none of these has paid off. Frankly, even if they are smashing successes, these markets, at best, help Intel achieve its current valuation, not grow beyond it.
This was borne out by recently reported sales trends. Intel has recouped most of the inroads by AMD from a percentage basis, controlling 81% of the processor market, up from 77% a year ago. But customers also increasingly buy budget processors, so the margins are low. The most damning part of this trend is that Intel has been investing more and more money to generate lesser returns. In 1997, it had a return on invested capital (ROIC) of 60. In 2001, it was 5. In June 2001, former Rule Maker manager Richard McCaffery wrote, "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. Whatever else happens, this is no longer true."
The bizarre dance
Intel's CFO Andy Bryant opined in a Wall Street Journal article last week that the company has a history of "doing the right thing," a position I don't completely share. Yes, Intel's executive options program is delightfully restrained compared to some of its high-tech brethren. Yes, Intel has paid dividends in the past, though they have been paltry. Yes, Intel has a history of producing significant free cash flow, and of making sound business decisions. But in the past few years, Intel has been a serial "overguider" when it comes to earnings, which has thus caused more than a few pre-announcements of poor earnings. Bryant is, after all, the same guy who said in July of 2000 that Intel was "more confident going into the third quarter than it has been in a long time." Yup, right at the beginning of a furious grind down of the PC market. Gank!
But most unforgivable was Bryant's insisting that gains of $2.3 billion from investment transactions be included as a part of Intel's core operating earnings, even though they were repeatable. Interestingly, the bleating about earnings from investments stopped at about the same time the bleeding from investments began.
And then there's options
Of course, I disagree with Andy Grove about options. I don't believe they're sufficiently accounted for simply by the diluted share count, because options have a nominal value over and beyond at-the-money dilution. I thought Alice Schroeder, an equity analyst at Morgan Stanley, had the best response to Bryant's claim that the value of options is already included in the earnings per share. Schroeder said:
As analysts, we were surprised to see the CFO of a Fortune 500 company make a public statement like this. There simply is no factual debate about whether the expense of stock options is already accounted for in earnings per share (it is not). We suggest that a simple review of standard accounting literature would resolve this issue easily for Mr. Bryant. We saw a recent survey that only about 20% of the CFOs of Fortune 500 companies are certified public accountants.
While obviously there is nothing magical about being a CPA, it does provide a basic toolset of skills that are helpful to those who must certify financial statements. When company CFOs have made similar remarks directly to us (and it's happened), it has made us feel we need to do more work to test the adequacy of the company's financial reporting and disclosures. All of these thoughts, we believe, are relevant to investors at a time when CFOs are attesting to the accuracy of the financial statements they file with the SEC and upon which we all rely. We believe the skills that CFOs bring to this task vary, and investors might want to consider that.
Ouch.
Of the three AeA members held by the Rule Maker, Cisco (Nasdaq: CSCO), Microsoft (Nasdaq: MSFT), and Intel, I have the least enthusiasm for making a statement by selling Intel. Intel's made more responsible capital choices than the others. However, I don't believe Intel's markets will improve anytime soon, and this company is dramatically different than when Rule Maker originally bought. So farewell.
As per The Motley Fool's trading guidelines, we'll sell Intel sometime in the next five business days.
Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards
For obvious reasons, Bill's wife rejected any thought of naming their daughter 'Anita.' Bill has beneficial interest in Cisco. Please view his profile for a full disclosure of his holdings. The Motley Fool has a disclosure policy.
The Rule Maker Portfolio has had a cumulative investment of $42,000. As of Aug. 20, 2002, its current value of all cash and equities is $27,523.07. This equals an Internal Rate of Return of -14% since the launch of the portfolio in February 1998.
