There's no question that semiconductor giant Intel (INTC -1.55%) is struggling. The company has made misstep after misstep on the manufacturing side of its business, squandering its lead to third-party foundries and opening the door for rival AMD to catch up. AMD is now competitive everywhere – desktops, laptops, and servers.
But struggling sure is profitable for Intel. The company grew revenue by 8% in 2020 to $77.9 billion, and it produced record operating cash flow of $35.4 billion. A surge in demand for PCs and cloud servers during the pandemic lifted all boats, even if that boat had some leaks.
Doubling down on manufacturing
This strong demand environment and the ongoing global chip shortage won't last forever. Intel will need to get its manufacturing back on track if it doesn't want AMD to keep stealing away market share. Under new CEO Pat Gelsinger, that's exactly the plan.
On top of continuing to manufacture most of its own chips, Intel is launching a foundry services business that will manufacture chips for other companies. Intel will also offer up its intellectual property portfolio to customers, including its x86 cores. While it may seem strange to take this step after years of manufacturing delays, the extra volume will help Intel make the massive investments necessary to keep pace.
Manufacturing chips for other companies has grown into a lucrative business. Foundries generated about $82 billion of revenue in 2020, and foundry sales are expected to top $90 billion this year. Taiwan Semiconductor Manufacturing (TSMC) is the dominant leader, with a market share above 50%. In 2020, TSMC generated roughly $48 billion of revenue and $18.6 billion of net income.
Given those numbers, it's no surprise Intel wants to tap into this growing market. Winning share from TSMC won't be easy, but Intel does have the advantage of being based in the U.S. Nearly two-thirds of the foundry market is in Taiwan. With tensions flaring between the U.S. and China, being able to offer U.S.-based capacity could prove to be a valuable asset for Intel.
Intel's comeback will take at least a few years to play out. The company doesn't plan to launch chips based on its 7-nanometer (nm) process until 2023, and it may use third-party foundries for some of those chips. AMD is already selling chips built on a 7nm process from TSMC, although the comparison is not exactly apples-to-apples.
Despite all the challenges it's facing, Intel still expects to produce adjusted earnings per share of $4.60 in 2021. That's down a bit from last year, but it's a price Intel must pay to regain its footing. The company expects research and development costs to rise this year to fuel its product roadmap and its new strategy, and start-up costs for its 7nm process will eat into the bottom line. The company also faces headwinds from shortages across the industry.
Intel stock currently trades for about 12 times that adjusted earnings guidance. The picture is admittedly a little less rosy when it comes to cash flow. Intel expects to produce free cash flow of $10.5 billion this year, good for a price-to-free cash flow ratio of about 21. Heavy capital spending will be necessary for Intel to build up its foundry business, especially with TSMC and other foundries ramping up their own capital spending plans.
There's no guarantee that Intel's strategy will work out. The company will need to convince foundry customers to trust it with manufacturing following years of manufacturing problems. But the Intel of the future, a mix of the old Intel and a foundry that can compete with TSMC, has the potential to be more profitable than the Intel of today.