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Intel
The Upside Case for Intel

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By alan81
June 15, 2001

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I believe that to invest intelligently we need to understand both the downside risk as well as the potential upside reward of the stocks we choose. To this end, the following is an attempt to generate an "upper bound" on the potential for Intel earnings over the next 7 years. I have mentioned before that Intel is not an investment for the weak of heart, but is something I currently consider a high risk, high reward play.

I see two major inflection points that Intel needs to successfully navigate in the near future. The first and more immediate inflection point is the conversion to 0.13u technology, P4 processor, and 300mm wafers. These three things are happening at about the same time, resulting in both a significant increase in product performance and reduction in product cost. It is highly debated if these changes will bring Intel into the undisputed lead in the processor race or sign the final death notice for the company. Successful navigation of this minor yet immediate inflection point only assures that Intel will hold on to what is already theirs.

After Intel navigates this "current" obstacle they have an even larger concern on the horizon. The processor market (80+% of current Intel revenue) is only growing at about 15% annually while the expectation is that Intel will grow at 18+%.  The secondary inflection is the new markets that Intel expects to penetrate. I was recently listening to Andy Grove on a Lehman brother's webcast:
 

The Premise
Andy mentioned that in 7 to 10 years he expects Intel to have revenue equally divided between three sources: One-third clients, which includes the current PC architecture, as well as cell phones and PDAs. One third Internet servers, which would include Xeon and Itanium processors, and finally one-third network silicon that connects the two together. If Intel successfully navigates into these two additional markets, and they are as large as Intel expects, they could radically increase revenue and profits over time.

The Math
I put together a mock P&L for the company over the next 7 years, starting with the forecasted numbers for 2001. I made a guess that in 2001 clients would account for $20B, servers at $4B, and networks at $3B. This results in total 2001 revenue of $27B, vs. 2000 revenue of $33.7B. I grew revenue from the reduced 2001 estimates rather than pretend this little problem we are having now did not exist. I then grew the client revenue at 15%/year, the server revenue at 45%/year and networks at 51%/year. This resulted in 2008 revenue of $161B, and EPS of $8.43, equally divided between the three business units.

In terms of expenses I proceeded as follows: Intel has announced intentions to significantly reduce the workforce this year, thus reducing expenses. I assumed 2001 expenses are roughly equal to 2000, as these cuts will not take effect immediately. This resulted in about $9B in R&D+MG&A spending in 2001, which I reduced to $8.5B in 2002. I then inflated this number at 10%/year for the next six years. In terms of gross margin I left 2001 at 50%, increased 2002 to 55% assuming some return due to .13u and 300mm, and finally to 60% in 2003 and beyond. I never let gross margin grow back to the 63% we saw in 2000.

The results of the math
With 2008 EPS of $8.43 I did a simple stock calculation using a P/E of 25, which shows a stock price growth rate of 32% assuming the current price of about $30 per share. If we assume the growth rate only needs to be 20%, then the maximum current stock price should be about $60.

What in the short term needs to happen for this to come true?
The Financials:
2002 Revenue needs to be back to $33.5B
2002 gross margin needs to increase to 55%
Return the company to the right size (smaller than now) for the current revenue stream

The products:
Win designs in the network space
Regain undisputed leadership in the PC space
Grow clients in addition to X86 (Xscale, cell phones, P884, etc...)
Retain low and mid range server market share with XEON
Gain high-end server market share with Itanium

The World
The model Intel is working toward assumes that people will be sharing rich media over the Internet. This rich media will require tremendous growth in both the server side and in the network, which causes much of the forecasted growth. The client growth remains moderate. We need to see an increased demand for both audio and video on the PC platform, and a willingness to pay for it to enable the growth in the infrastructure.

Any suggestions on changes in assumptions or mathematics would be appreciated. For you bears out there, remember that I started out by saying this is unlikely, but rather it is intended to show a potential upper bound and hence potential reward that we could reap given we are currently assuming a fair amount of risk. In summary, the downside risk I have heard is a stock price of about $15, or half of current value, and this analysis shows an upside potential of about $60, or twice the current valuation, with a growth of 20%/year on top of that. I believe the most likely answer lies somewhere in between these two extreme cases.

--Alan