Dan Ferris writes about two of this planets largest industry dominators and why it is just plain common sense to hold these in your portfolio. Intel more so than Microsoft, is such a money tree when it comes to option plays. I always do a covered call on my positions because of the dividend growth.
By Dan Ferris
Intel (Nasdaq: INTC) dominates the global computer-chip market with an 80% share of PC microprocessors and a 90% share of processors for large server computers for big companies and data centers. Its 4% yield is among the highest we've ever found in a world dominating stock. Intel is at the top of its field and as we'll show boasts a strong balance sheet and growing sales and profits.
And yet, investors have abandoned the stock. Intel's share price bottomed last November below $20 a share. After hitting that low, Intel peaked at $25.65 a share on June 18. Since then, the stock is down about 11%, trading just around $22 today. Why is the market bailing out?
As consumers migrate from personal computers to mobile devices, investors expect a decline in global PC shipments. PC makers Hewlett-Packard, Dell, and Lenovo are Intel's three largest customers. They accounted for 42% of Intel's sales in the first half of 2013. Investors worry such a large commitment to a beleaguered PC market could mean disaster for Intel.
Five of the last eight Wall Street analyst decisions on Intel – as tracked by Wall Street estimate trackers Thomson/First Call – were downgrades from previous ratings. The ratings themselves are all technical Wall Street-speak, like "market underperform" and "sector outperform." All you need to pay attention to is the direction of the rating. And in this case, Wall Street is bearish and selling Intel shares.
Looking purely at Intel's sales and profits of the first half of this year, you'd think Wall Street was right.
Intel sales fell 5.1% in the second quarter of 2013 versus the same period last year. That led to a 29% drop in operating income.
Intel reports financial results of five distinct business groups. Two of them generate all the profit. The PC Client Group is the largest. This business makes chips for PCs and laptops. It's has an 80% global market share of PC microprocessors. It accounted for 63% of Intel's sales and 68% of its profits last quarter (not including divisions that produced losses). This is one of two businesses – the other is the Data Center Group – that make Intel the World Dominator of the global semiconductor industry.
PC Client Group sales were down 6.7% in the first half of 2013, and operating income was down 25.4%. Most folks expect sales and profits to continue to decline as global PC shipments slow.
The PC market will ship 300 million units this year, according to forecasts by industry watchers at Gartner Group. That's about 10% or 11% below last year. But it's still a huge market, and it should provide Intel with well over $10 billion of profit this year. Despite a consumer trend toward mobile devices (like tablets and smartphones), PCs and laptops should continue to be a huge source of sales and profits for Intel for at least a few years.
Mobile technologies are on the rise. But Intel's mobile-device businesses are so small today, they barely show up on its financial results. They're part of its "Other Intel Architecture" division, which accounted for just 7.4% of sales last quarter and has yet to produce steady profit.
But that's changing. What Wall Street doesn't understand is Intel is not a static pile of outmoded technologies. It's a dynamic, growing, constantly changing business that has maintained the lead in its industry and set the pace of innovation for decades. Intel makes the most advanced (smallest) computer-chip components in the world. It employs over 100,000 people worldwide – the biggest concentration of semiconductor engineering talent in the world.
Intel's battle against falling PC sales isn't the whole story. Intel has invested tens of billions of dollars the last few years to maintain and grow its competitive advantage over the rest of the industry. From 2010 to 2012, Intel spent just over $25 billion on research and development (R&D) and about $27 billion on capital expenditures (land, buildings, and machinery).
That's over $52 billion invested by the most advanced company in the industry on the most advanced chip-making technology available. I'm confident that's worth a lot in terms of future earnings. We're seeing the fruits of Intel's R&D already.
Over the next few months, Intel plans to release new products for a market it doesn't yet dominate (tablets and smartphones) as well as new products for the markets it already dominates (PCs, laptops, and servers)...
Samsung recently introduced its new 10.1-inch Galaxy Tab 3 tablet computer – run by Intel's Atom processor. Intel expects to launch the next generation of Atom processors (codenamed Silvermont) in the second half of the year. This will include a version of Atom for smartphones (codenamed Merrifield) and versions for PCs and tablets (codenamed Bay Trail). Intel also expects to start shipping the next version of Atom for small servers (called microservers) in the second half of the year, as well as a new version of its Xeon server chip.
Right now, Intel doesn't have enough business to use all of its manufacturing capacity. Reports suggest Intel's semiconductor plants are running at about 50%-60% of their capacity. Normal capacity is 95%, as Intel always likes to keep some capacity in reserve. Right now, Intel is like a Ferrari stuck in the slow lane. It can do a lot more than this.
Semiconductor manufacturing plants cost billions of dollars to build. They're designed to run 24 hours a day, seven days a week. They're not doing that right now. One new Intel plant in Arizona isn't operating at all, and equipment that was originally destined for it was sent to Intel's Hillsboro, Oregon facilities instead.
Intel has spent lots of money to build lots of extra capacity. But it simply hasn't received enough orders to run the plants at full capacity yet. Some people think this signals a disaster. We think it's just Intel preparing for the future.
When Intel plants make fewer products or even sit idle, the business becomes less profitable. Intel's gross profit margin fell sharply, from 63.4% in the second quarter last year to 58.3% last quarter. On first glance, that looks bad. But believe it or not, there's good news here. Let me show you why...
Why Intel Is in Much Better Shape Than You Think
Intel's primary market is declining. It has delayed entry into the mobile-computing and phone markets. It's not using much more than half of its very expensive manufacturing capacity. And yet Intel is still capable of generating a 58%-plus gross profit margin. Compare that to Taiwan Semiconductor (which we'll discuss in a minute), which generates less than a 50% gross margin and Taiwan-based UMC Corp, which earns just a 19% gross margin.
Intel more than doubled its annual capital spending from $5 billion two years ago to more than $11 billion last year. Its sales are down the last six quarters. So it's spent a lot more in recent years and finds itself earning less today. Free cash flow was over $11 billion two years ago. It fell below $8 billion last year. Don't focus on the $3 billion in cash flow that isn't there. Intel still generates $7.9 billion in free cash flow. That's way more than enough to cover its $4.5 billion in annual dividend payments. So there's no risk Intel will cut its dividend. This is one of the safest dividends in the world.
Even with PC shipments crashing and excess capacity sitting idle, Intel is still one of the most profitable, cash-gushing companies in the world. And it's one of the safest dividend-payers around. In the second quarter of 2013, with sales and profits falling, Intel earned more net profit than all but 18 non-financial S&P 500 companies. And the second quarter was one of its worst performances in years.
One reason Intel invested tens of billions of dollars in new manufacturing capacity is so it can get into the computer-chip "foundry" business. A foundry manufactures other companies' products... and it can be a great business. Taiwan Semiconductor is a computer-chip foundry. It has many of the financial clues of a great business, too... high returns on equity, consistent profit margins, decent free cash flow, a great balance sheet, and consistent dividend payments.
But Taiwan Semiconductor doesn't own the most advanced semiconductor manufacturing plants in the world. Only Intel can make that claim. Intel's foundries will begin producing chips with components just 14 billionths of a meter (14 nanometers) later this year. More components in a smaller space means more computing power per square millimeter. The smartphones of today are far outperforming the huge room-sized machines that started the computer age. Intel's smaller chip components get much of the credit for that. Smaller is better smallest is best. And any company that wants to make the smallest components must go to Intel.
There's simply no one else doing that. No existing foundry can compete directly with Intel's unique ability to make the smallest components ever put on a computer chip. The rest of the industry is still making 20 and 28 nanometer chips. Intel is way ahead of the rest of the industry.
Intel is attracting foundry customers who need its cutting-edge technology. It's already got five of them – including Altera, a $1.8 billion revenue chip-design firm that recently announced it would use Intel as a foundry. Intel's newest foundry customer is Microsemi, a $988 million revenue chip designer. These are much bigger than the tiny startups Intel's foundry attracted before.
But Intel's foundry business won't be a major profit contributor until it attracts a giant customer like Apple or Texas Instruments. If and when that happens, the stock could soar 10% in a single day. I bet such an announcement is inevitable, though no one knows for sure when it'll happen.
One of the primary ways competitors (like mobile-device chip-designer Qualcomm) have outperformed Intel is by making chips that use less power. These are necessary for making smaller devices, which can't handle large batteries. Intel is on the cutting edge here, too...
Apple recently announced two brand-new Macbook laptops. Both have new, fourth-generation Intel Core microprocessors in them. The 11-inch Macbook's battery will last up to nine hours on a single charge. The 13-inch version will last up to 12 hours (according to Apple's website). Even if the real performance is a couple hours shy of those numbers, it's a major leap forward in laptop battery life. I've never owned a laptop that lasted more than about two hours on a single charge. Imagine the feeling of freedom you'd get from not carrying a clunky charger around all day long. It shouldn't be long before Intel chips with longer battery lives start showing up in other devices.
You can't buy the past. A business' value depends on its future cash flows. We think Intel's big investments of the last few years have sown the seeds for much higher sales, profits and therefore dividends in the years to come.
Intel yields 3.8% when trading at $24 per share. If you invest in Intel at that price and it raises its dividend at just 10% a year, you'll soon find yourself earning much more than 3.8% over your original cost.
Within three years, you'll be earning a 5% yield over today's share price. You'll be earning 6% over today's share price in five years... and 9.8% within 10 years. Wait another 10 years after that, and you'll be earning an astounding 25.2% over your original cost. Maybe the dividend won't grow that fast for that long. But even if it grew half as fast, you'd still be earning one-tenth the current share price per year within 20 years.
Here's how we recommend you "boost" your income with Intel.
How to Turn $2,400 into $22,000 with Intel
Let's assume you buy 100 shares at $24 and reinvest all your dividends. Assuming 10% annual dividend growth and 5% annual share price growth, you could turn an initial investment of $2,400 into nearly $22,000 in just 20 years...
The easiest and fastest way to reinvest your dividends is through a dividend reinvestment plan (or "DRIP"). To enroll in Intel's DRIP, just contact your existing broker. Brokers usually don't charge a penny to set you up... nor do they charge commission for shares bought with reinvested dividends.
Based on dividends alone, you can see why Intel is such an attractive income investment for The 12% Letter. The rest of its financials look just as strong...
Intel's Financial Clues Say It's a Fantastic Business
There are specific clues we look for in each stock we recommend. Intel has all of them. It's a strong, unbeatable giant.
Consistently High Returns on Equity
You can't base an investment decision on a single number. But if you could, that number might be "return on equity" (ROE). This number, perhaps more than any other, tells shareholders if they're holding onto a wonderful business or a dud.
Think of a business as a savings account and its earnings as the interest you earn on those savings. It's obviously more complicated than that, but that's the gist of ROE. Over the last 10 years, Intel's ROE has been as low as 10.5% (during the recession of 2009) and as high as 28.2% (in 2011). Over the last three years, it's averaged about 24.5%. Just imagine a bank account that pays you 24.5% interest every year, instead of 0.05%. You wouldn't bother looking for other places to put your money.
Consistent Profit Margins
A consistent profit margin means a company is able to keep competition at bay and consistently create plenty of value for its customers. Over the last 10 years, Intel's net profit margin has ranged consistently from the low teens to high 20s. These are very high numbers. Last quarter – which was widely viewed as a disappointing performance – Intel's net profit margin was 21%. That put it in the top 17% of the S&P 500. Only an incredibly profitable business can continue to crank out 21% net profit margins in the face of a global downturn in its primary source of revenues and profits. It's really hard to hurt a global dominator's profitability, and Intel is probably the best example of that right now.
Gushing Free Cash Flow
Free cash flow = operating cash flow – capital expenditures.
Intel's free cash flow has fallen from about $11.5 billion in 2010 to $7.9 billion in 2012. That's not because the overall business is shrinking... Sales have risen from $43.6 billion to $53.3 billion during that time. The reason Intel generates less free cash flow today is that it's investing more cash flow back into the business. As we said... Intel invested a total of $52 billion in research and development and capital spending from 2010 through 2012. Today, it owns a one-of-a-kind asset: The most advanced computer-chip manufacturing facilities in the world.
We like the huge increase in Intel's capital spending over the past few years because we believe Intel's new investments will widen its competitive advantage over the rest of the semiconductor industry. They could add many billions in new sales at very high profit margins over the next few years.
Financial Fortress Balance Sheet
Intel is in better financial condition than the vast majority of companies in the world today. It has $22.7 billion of cash and securities and $13.4 billion of debt. So it could pay off all its debts and still have more than $9 billion in cash left over. It's like having a $200,000 mortgage and $338,000 in cash in a bank account. Like with many global dominators, Intel's balance sheet provides more than enough financial security, helping shareholders sleep well at night.
Shareholder Rewards – Share Repurchases and Dividends
Intel spent $1.4 billion on share repurchases in the first half of the year. Intel is good at buying back shares. It has reduced its share count every year since 2004. The current share count is about 20% less than it was nine years ago. Reducing the share count raises the value of the remaining shares and helps make it easier to increase dividends.
Again, Intel hasn't raised its dividend yet this year... and it has spent a lot less on share repurchases in the last couple years ($12.3 billion in 2011 and $3 billion in 2012). That's because it's ramping up the investments in its cutting-edge technology and new fabrication plants. We don't mind this at all. We'd much rather receive a little less income today so Intel can maintain and grow its competitive advantage in the global chip industry, assuring it'll pay plenty of dividends in the future.
Intel Is Such a Strong Business,
We're Raising Our Maximum Buy Price
The financial clues clearly indicate Intel is a safe, cash-gushing World Dominating Dividend Grower – despite investor fears of a declining PC market. It will continue to dominate the PC market. But it's also breaking into the mobile-device space, ramping up for new mobile-computing chips. The foundry business continues to attract larger customers, and we think it'll eventually attract a mega-customer, like Apple or Texas Instruments.
The stock yields 4% today. The dividend might not go up again this year, but there's little chance it'll fall. Meanwhile, the company trades at an enterprise value (market cap + debt – cash) of about 10.4 times free cash flow (of the last four quarters). That's cheap for one of the best businesses in the world. As Intel's new businesses grow, so should sales, profits, free cash flow, and dividends. That'll help the market recognize its value, raising the share price above today's depressed levels.
Intel's share price may have farther to fall in the near term. It could sink below $20 again, like it did last fall, before jumping higher. But we're focused on earning income from the biggest, safest companies in the world. All we need to know here is that Intel is a dirt-cheap World Dominating Dividend Grower that – no matter what Wall Street thinks – will continue to dominate the semiconductor-chip market for years to come.
Therefore, we're willing to raise our buy-up-to price on Intel from $22 per share to $24 per share. At that price, it would trade at an enterprise value of just under 12 times free cash flow and pay a 3.8% dividend yield. We believe you could make double-digit total returns on this stock over the next three to five years, assuming capital gains and a growing dividend of 6% or more a year.
BUY Intel (Nasdaq: INTC) up to $24 a share. The stock trades around $22 today.
Why Most Folks Have Microsoft all Wrong...
Just like with Intel... investors have Microsoft (Nasdaq: MSFT) pegged all wrong.
When you mention Microsoft to many investors, they start talking about declining PC shipments and therefore declining sales of Microsoft's Windows operating system (which appears on about 90% of them). It seems like everywhere you turn, folks think Microsoft is doomed.
But Windows hasn't been Microsoft's No. 1 source of sales or profits for three years. And consumers aren't its biggest customers. Windows is No. 2 in profits and No. 3 in Microsoft sales today. And sales to big and small businesses – not individual consumers – make up almost two-thirds of Microsoft's revenue.
Microsoft has two divisions with higher annual sales than Windows. The Microsoft Business Division (MBD) is the largest division by sales and profits, with $24.7 billion in sales and $16.2 billion in operating income last year. MBD sells the popular Office productivity suite, which includes Word, Excel, and PowerPoint.
Office has over 1 billion users worldwide, a little more than three times the U.S. population. Big and small businesses account for 85% of Office sales.
Microsoft recently introduced Office 365, an online, subscription-based version of Office. Office 365 is the biggest hit product in company history. Last quarter, it added more new users than in all of 2012. It already has annual sales of $1.5 billion.
If Microsoft can get just one-third of its 1 billion global customers paying $100 a year for a subscription to Office 365, it's looking at $33.3 billion in revenue... more than one-third higher sales than MBD is doing today. This is one product, not tied to Windows, that could make Microsoft a substantially bigger company than it is today.
Microsoft's second-biggest business is Server & Tools (S&T), with $20.3 billion in sales and $8.2 billion in operating income last year. It sells software that's considered critical for the day-to-day operations of big companies. S&T has six separate businesses... some of which are growing sales at double-digit rates. One of them, SQL Server, is the most widely used database product in the world. SQL Server sales grew 16% last quarter. Another one, Windows Server, is used on 75% of the world's servers (big computers processing large amounts of data at large companies).
Microsoft has 16 businesses in its various divisions – 16 brand names – that earn at least $1 billion in revenue each year. Billion-dollar brands are rare. Companies that own a lot of them are even rarer and are very hard to compete with (including Coca-Cola with 15 and Procter & Gamble with 27). Microsoft gets too much criticism for Windows and not enough credit for all its other billion-dollar brands. Microsoft is not all about Windows anymore. It's not all about consumers. It's not all about global PC demand.
Microsoft's Financial Clues Say BUY
My advice to investors is that you should stop thinking of Microsoft as a has-been, PC-based company and start thinking of it as a royalty on the growing global information technology infrastructure.
All the financial clues are pointing in the right direction.
Consistently High Returns on Equity
Microsoft's return on equity (ROE) has ranged between 31% and 48% for most of the last 10 years. It's around 28% or so these days. So Microsoft is like a bank account that makes 28% or so on the money you deposit into it. The business doesn't require much investment to maintain and grow itself. That means it has more cash available for dividends and share repurchases today as well as almost guaranteeing there will always be plenty of excess cash in the bank just in case it's needed.
Consistent Profit Margins
Microsoft has consistently earned gross margins in the range of 70%-80%. Last year was no different, with gross margins of about 74%. This is higher than the vast majority of businesses in existence today. Microsoft's software is highly valuable and very cheap to make. That keeps profit margins thick. And now that Office 365 makes downloads available on the Internet, it doesn't even require you to manufacture disks anymore. (That should also cut down on piracy, increasing profit margins.)
Gushing Free Cash Flow
Free cash flow = operating cash flow – capital expenditures.
Few businesses in existence today gush rivers of free cash flow like Microsoft does. Last year, Microsoft's business generated $24.6 billion in free cash flow. That's less than last year's record amount of $29.3 billion. But it's still plenty of extra cash (100% more than what's needed to maintain and grow the business) to go toward dividends and share buybacks... with a lot left over. In fact, Microsoft earns more free cash flow than any non-financial company in the S&P 500 except Apple. Microsoft generated $0.32 of free cash flow for every $1 it earned in sales. That's incredible.
Financial Fortress Balance Sheet
Imagine having cash in the bank equal to five times your total mortgage and credit card debts. You'd probably be the most financially secure person you know. That's how Microsoft is. It's one of the most financially secure businesses on Earth.
Microsoft has $77 billion in cash and securities and $15.6 billion in debt – slightly less than five times as much cash as debt. Plus, the interest on Microsoft's investment portfolio more than covers the interest payments on its debt. Microsoft earned $288 million in interest last year, after covering interest payments on its debt. It's almost like a bank, which earns the difference between its investment interest and the interest on its debts and deposits. The chances of Microsoft having any type of financial difficulty are virtually zero. It's still one of the safest stocks in the world.
Shareholder Rewards – Share Repurchases and Dividends
Last year, Microsoft bought back $4.4 billion worth of stock. It has reduced its share count by about 23% over eight of the last nine years. We are highly confident this will continue. That'll make each remaining share more valuable as time goes on.
Microsoft also paid out $7.5 billion on dividends last year. So it paid out about half of its $24.6 billion in free cash flow. That's good but it has the ability to pay out more in share repurchases and dividends. I think it'll do that over the next several years. Right now, Microsoft yields 2.8%. Its ongoing growth and cash-gushing ability will enable it to continue to raise its dividends for years to come.
Microsoft is deeply undervalued, even if you take Windows out of Microsoft entirely. If you subtract all of Microsoft's excess cash, it trades today at just 8.3 times trailing free cash flow. It's worth at least mid-teens.
It's also cheap. By my estimate, MBD and S&T alone would still generate about $20 billion a year in growing free cash flow (adjusting for lower corporate expenses). The current enterprise value is about 10.5 times that too cheap for a cash-gushing global stock with consistently thick margins and a financial fortress balance sheet. The share price is around $32 today. It should be at least low $40s.
At an enterprise value of 12 times free cash flow, the shares would trade around $52. That's roughly 65% above today's share price. That seems like a big jump, but it's a reasonable valuation. The difference between 12 times free cash flow and today's share price represents a huge margin of safety for equity investors who buy today.
Microsoft isn't doomed. It's merely misunderstood. Today's share price doesn't give it enough credit for the 16 billion-dollar brands it owns – 15 of which have nothing to do with Windows, many of which are highly profitable, and some of which are growing sales at double-digit annual rates. That's why last week, we raised our maximum buy price from $30 to $34 per share. Between the rise in valuation and growing dividends we expect, you could make a double-digit income on this stock over the next five to seven years, with minimal risk.
BUY Microsoft (Nasdaq: MSFT) up to $34 per share. Right now, shares trade around $32.
• Watch a video to learn more about the Atom processor Intel developed for phones and tablets here.
• Technology investors should visit the Gartner Group newsroom every couple days. It'll help you keep up
with global PC, smartphone, and tablet sales... including market-share data for the biggest suppliers.
Access it here. _____________________________________________________________________________________________________________________