Rule Maker To Buy INTC
February 12, 1998

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Rule Maker Portfolio Buy Report (released 2/12/98)
Announcement: Purchasing $1,875 in Intel stock.

Intel Corp. (Nasdaq: INTC)
2200 Mission College Blvd
Santa Clara CA 95052-8119
Phone: (408) 765-8080
Fax: (408) 795-1596
Web: www.intel.com

An Overview of the Company

Our first Rule Maker purchase was Microsoft, the company that makes the operating system for 90% of all the world's personal computers. Now, our most recent and fourth purchase will be Intel, the company that has 90% of the market for the microprocessors (or brains) that drive those computers and other devices. Intel also makes microcontrollers, flash-memory chips, networking products (much to the chagrin of companies like 3Com), and videoconferencing systems.

In a real sense, no joke -- Intel founded Silicon Valley, one of the most profitable commercial regions in the United States. The company remains the dominant force in the area. This past year, Intel's CEO, Andy Grove, was named Time Magazine's Man of the Year.

Basic Financials

Price (as of 2/10/98)............$84.75
Trailing earnings..................$3.87
Fiscal 1998 Est. Earnings....$3.97
Fiscal 1999 Est. Earnings....$4.54
P/E on Trailing Earnings.......22x
P/E on This Year's Est.........21x
P/E on Next Year's Est........19x

Basic Rule Maker Criteria

Market Cap...................$152.5 billion
Cash & Equivalents........$9.9 billion
Gross Profit Margin.........60.3%
Ave.Net Profit Margin.......27.7%
Cash-to-Debt...................22x
Flow Ratio.......................0.99

Additional Financial Data

Consensus 5-Year Growth Rate..19.5%
Debt as % of equity....................2%
Debt as % of revenues................2%
Dividend Yield............................0.14%
Return on Equity........................36%
Return on Invested Capital...........37%

Concentrated Look at the Business

It has been 26 years since Intel introduced the world's first microprocessor, making technological history and forever changing our world. Today, Intel supplies the computing industry with the chips, boards, systems, and software that are the "ingredients" of computer architecture. Intel's mission is to be the preeminent building-block supplier to the new computing industry worldwide.

Company Products

Intel's processor products carry the business, accounting for 80% of its overall business. These products include:

  • Microprocessors, often called central processing units (CPUs) or chips. Microprocessors are frequently described as the "brains" of a computer because they control the central processing of data in the box.
  • Chipsets, which perform essential logic functions surrounding Intel's CPU.
  • Motherboards, which combine Intel microprocessors and chipsets to form the basic subsystem of a PC or server.

Second up, Intel's networking and communications products enhance the capabilities of PC systems and networks. These products are sold through reseller, retail, and original equipment manufacturer (OEM) channels.

Finally, Intel offers computer-enhancement products, like flash memory. (Don't be scared off by the oncoming jargonish tones.) Flash memory provides reprogrammable memory for computers, mobile phones, and many other products. It has the advantage of retaining data when the unit's power is turned off. Also, Intel offers embedded control chips designed to perform specific functions in products such as automobile engine and braking systems, hard-disk drives, laser printers, input/output control modules, cellular phones and home appliances.

The Company's Major Customers

  • Original equipment manufacturers of computer systems and peripherals. (e.g. Compaq, Dell, Gateway)
  • PC users, who buy Intel's PC enhancements (such as overdrive chips), business communications products, and networking products through reseller, retail, and OEM channels.
  • Other manufacturers, including makers of a wide range of industrial and telecommunications equipment.

Key Management

Chairman Emeritus: Gordon E. Moore, age 68
Chairman and CEO: Andrew S. Grove, age 60
President and COO: Craig R. Barrett, age 57

EVP; GM, Small Business & Networking: Frank C. Gill, age 53
EVP; GM, Tech. & Manufacturing: Gerhard H. Parker, age 53
EVP; Director, Sales & Marketing: Paul S. Otellini, age 46
SVP; Director Business Development: Leslie L. Vadasz, age 60
SVP; GM, Content: Ronald J. Whittier, age 60
SVP; GM, Microprocessor Products: Albert Y. C. Yu, age 55

Historical Stock Performance

Over the past five years, Intel's fully diluted earnings per share (EPS) have grown sequentially by 110%, 1%, 54%, 44%, and most recently 33%. The annual compound rate of earnings increase was 44% during that period. The stock price has tracked that growth, increasing by 43%, 21%, 38%, 57%, and most recently by 7% for the fiscal year ending December 31, 1997. This equates to an annual rate of stock price increase of 45% for the five-year period.

As noted in the table above, gross margins are currently 60%, up from 56% in 1992. However, Intel has been warning for a long time that it expects gross margins to decline in the years ahead, eventually stabilizing within a few points of 50%. Growth in every measure of return (i.e., net margin, return on equity, return on sales, and return on capital), though, is higher now than the average over the last five years. In short, Intel's performance has been stellar in the past. There are questions about future margins, but with net margins above 27%, we're comfortable with moderate declines.

Concerns Going Forward

Intel has competitors for its microprocessors, particularly at the low end. These competitors will continue to threaten margins for lower-performance CPUs. If computer users don't continue to demand higher-performance products (which they've been doing for a decade), then revenues and gross margins may be severely impacted.

This is of particular concern right now, as the vast majority of existing software runs quite well on existing processors and most performs acceptably on older Pentium chips. As a result, Intel makes a practice of funding development in new software and Internet companies that create speed-demanding applications to keeps us chomping at the bit for more computing power (e.g. witness Intel's recent investments in C-Net).

Next up... Intel's gross margin percentage is sensitive to the product mix sold in any period. The percentage of motherboards purchased increases with the product cycle, and motherboards generally have lower gross margins than microprocessors. This highlights the importance of demand continuing to grow for Intel's high-end products.

In addition, it should be noted that building capacity for producing these chips is very expensive. A multiprocessor fabrication plant (a "fab") can cost more than $2 billion to build. This acts as a nice deterrent to competition -- who can keep up with Intel's fab growth? -- but also presents Intel with the risk of having to manage demand against expensive capacity.

Prospects Going Forward

In truth, though, Intel's competition for the sale of microprocessors is relatively small. Its best-known competitors in this area are Advanced Micro Devices (NYSE: AMD) and National Semiconductor (NYSE: NSM). Intel spends more on research & development than either of these companies take in on sales (sounds a bit like Microsoft and its competition in the Internet browser market, Netscape (Nasdaq: NSCP), cf. CK Microsoft Buy Report). Given its strong leadership position, Intel really has the computer makers beholden to it. PC manufacturers cannot afford to ignore Intel for fear of running short on high-quality chips.

Even with its large lead, Intel continues to pressure its chip competitors by dropping prices on older models. As noted above, the margins on these lower-end processors are smaller, but still quite high. Advanced Micro and National Semiconductor, however, do not enjoy these high margins because they lack Intel's economies of scale and established fabs. It's pretty clear that our company can look forward to continued dominance of the PC microprocessor market.

Intel continues to make inroads in other markets as well, particularly networking, and the new market for digital voice/ video applications. The demand for processing speed is expected to pick up in the next few years as much faster Internet connections become more commonplace. Last, but by no means least, Intel recently announced that its next generation chip, the Merced, will debut in 1999. This chip is expected to first serve the high-end servers and workstation market, and eventually move into the desktop market. The high-end market, in quantity, is a new market for Intel, and one that promises higher-margin sales.

Intel's future prospects are very bright indeed.

Why Intel is a Rule Maker Stock

Intel easily passes most, if not all, of our Rule Maker financial tests. The only concern on the numbers is Intel's warning on gross margins, but even if they do eventually stabilize around 50-52%, that meets our Rule Maker standard of 50%. Elsewhere on the income statement, Intel's sales and earnings growth has been healthy. It is spending just shy of 10% of its sales on research & development. And the company sports outrageous 27%+ profit margins.

On the balance sheet, the company's debt is nominal at $448 million, and it has almost $10 billion in cash and marketable securities, and we find the Flow Ratio at 0.99. If you have any questions about this data or these relationships, please read through our 11 Steps to Rule Maker Investing.

Beyond the numbers, Intel certainly has a global brand name. It has worked hard to extend this brand to the consumer with its "Intel Inside" advertising campaign. Past performance has been exemplary, and the future looks equally promising. Now, arguably, Intel is not in a repeat-purchase business. Most people don't buy a new computer every day, week, or month. However, an increasing number of people do use their computer every day. As Intel brands its chips in the mind of consumers, it produces some, though not all, of the advantages of a repeat-purchase business.

Finally, and worth note, Intel is one of the best examples of a public company that communicates well with its shareholders. It has set the model for technology companies to pre-announce opportunities and shortcomings. Investors should stick close to its website, should call its Investor Relations Department when questions arrive, and -- of course -- should ask the community of investors about their take on the business in our Intel stock folder.

We are extremely pleased to make this the next purchase for the Rule Maker Portfolio. We don't consider ourselves geniuses for digging this one out. Nope... just Fools.

Fool on!

--Al Levit