2023-05-01 12:40:34 ET
Summary
- Intel Corporation's declining gross margins and persistent concerns about end-demand and competition raise red flags for investors.
- A recovering China could provide pricing tailwinds that may help alleviate Intel's gross margin issues.
- Valuing Intel remains challenging due to its deteriorating financial metrics and uncertainty surrounding its competitive strength and future earnings.
Earlier in the year, we wrote about the Intel Corporation ( INTC ) risks and opportunities following its datacenter and AI webinar. We concluded by assigning a Sell rating to Intel stock due to the company's financial struggles and deteriorating competitive position.
While the market has reacted favorably to Intel's recent Q1 earnings results , our careful analysis suggests that these results further substantiate our concerns. We remain particularly troubled by the company's gross margins for the quarter and management's outlook, which indicates a continuation of this concerning trend.
However, we acknowledge that sentiment on the stock is extremely bearish, and the bar has been set very low, which historically provides a fertile ground for generating excess returns with positive surprises. Specifically, we believe a recovering China could offer the best hope for Intel in the near term.
Q1 Key Takeaways
Although Intel's 1Q23 financial report was initially viewed positively by the market, our analysis argues that it should be raising alarm bells for investors instead. Although revenues of $11.7 billion surpassed the FactSet consensus by 6%, the company faced a significant 36% YoY decline. Most segments struggled, with only Mobileye showing a 16% YoY increase in revenue. The other segments - CCG, DCAI, NEX, and IFS - exhibited troubling declines of 38%, 39%, 30%, and 24% YoY, respectively.
The disappointing non-GAAP gross margin of 38.4% (excluding stock-based compensation, or SBC) fell short of the company's guidance by 60 basis points, primarily attributable to unexpected inventory reserves. Intel's 2Q23 revenue guidance of $12.0 billion at the midpoint, a 2% QoQ increase but a 22% YoY decrease, is far from encouraging. The lighter-than-expected gross margins are primarily driven by ongoing concerns related to PC and server end-demand and cutthroat competition. Intel's non-GAAP gross margin (excluding SBC) guidance of 37.5% versus 41% should be a significant red flag for investors.
Despite this gloomy outlook, Intel's management team, led by CEO Pat Gelsinger, expressed comfort with 40%+ gross margins for 2H2023. However, it is crucial to remember that these margins have been bolstered by accounting changes. Intel recently altered its depreciable life of equipment from five to eight years. The 10-Q report highlights a $460 million impact from this change in 1Q23, which brought a $360 million benefit to GM% and a $100 million decline in R&D expenses. For 2Q23, Intel anticipates a $500 million benefit, with a GM% benefit of approximately $400 million. While the change in depreciation life is expected to result in a $2.3 billion GM% benefit for 2023, the fact that the 40% level gross margin is only achievable with accounting adjustments makes the situation more worrisome than it initially appears.
Intel's financial performance and future guidance present a precarious situation for investors. Although the company may be exceeding revenue expectations, the declining gross margins and persistent concerns about end-demand and competition should not be overlooked. We urge investors to closely monitor Intel's ability to maintain margins and market share amid an increasingly competitive landscape
Intel Q1 Also Offers Reasons For Hope
While we express concerns about Intel's financial performance and future guidance, it is crucial to maintain a balanced view. One positive aspect for Intel is that the bar has been set very low, enabling the company to report better top and bottom lines compared to extremely bearish consensus estimates. This marks the first time in a while that Intel has outperformed expectations, providing investors with a glimmer of hope that the company may see better days ahead.
During the earnings call, management noted that they have undershipped the PC total addressable market, or TAM, by approximately 20% in Q1 and expect further undershipping in Q2. Additionally, the company highlighted "green shoots" in China following a period of significant weakness. We believe that this bullish commentary on China is consistent with many other companies' Q1 earnings, such as those of KLA Corporation (KLAC). A recovering China could provide pricing tailwinds that may help alleviate Intel's gross margin issues.
We also appreciate the progress Intel has made in its cost-cutting efforts. However, we remain cautious that the company might cut too deeply, potentially harming its competitive advantage even further. Nevertheless, it is encouraging to see these cost cuts reflected in the numbers.
Could China Save Intel?
We find Elon Musk's observation that the most ironic outcome is often the most likely outcome quite intriguing. In the current scenario of a chips war between the governments of the U.S. and China, with Intel being positioned as the champion of U.S. semiconductors, it would indeed be highly ironic if the recovery of China's market provided a positive catalyst for turning Intel's trends positive.
A month before Intel cited green shoots in China, Goldman Sachs upgraded its outlook on the nation's economy, driven by a strong recovery in sectors sensitive to the Covid-19 pandemic and broadly improved activity data in the first two months of the year. Goldman Sachs raised its GDP forecast to 6% from 5.5%.
Now that Q1 is over and GDP numbers are out, China's economy has rebounded faster than expected, surpassing growth estimates for the first quarter of the year. The country's economic growth was fueled by the relaxation of its stringent Covid-19 restrictions and a surge in consumer spending. According to the National Bureau of Statistics, the world's second-largest economy grew at a rate of 4.5% compared to the same quarter a year earlier, beating the 4% rise forecast by analysts polled by Reuters.
China's consumer economy has shown signs of resurgence, with retail sales rising 10.6% in March, the largest jump in almost two years and more than double the forecast rate. Industrial production also increased by 3.9% during the same month compared to a year earlier, reaching a five-month high.
Not only does economic data support Intel's bullish call on China, but other companies also share this positive outlook. KLA's recent Q1 earnings call mentioned that China is performing stronger than anticipated. The infrastructure investment in China, particularly in the wafer and reticle sectors, is considered an inflection point. Similarly, Silicon Laboratories Inc. ( SLAB ) reported in its recent Q1 earnings that they are witnessing encouraging signs of strength and recovery in China, with all indicators pointing towards positive momentum.
These optimistic observations from industry leaders like KLA and Silicon Laboratories provide hope for other semiconductor companies, such as Intel, to potentially benefit from China's robust recovery and resurgence in the semiconductor market.
Valuation: More Art Than Science
Our analysis of Intel's financial performance highlights the significant headwinds the company is likely to face in the coming years. Factors such as weakening end markets, competitive share losses to Advanced Micro Devices, Inc. ( AMD ) in the x86 space, and the shift in computing from CPUs to accelerators like Nvidia's GPUs have contributed to Intel's decline. The company's revenue is projected to continue falling, with a CAGR of approximately -13.4% from 2020 to 2023.
Intel's capital-intensive business model, compared to fabless competitors like AMD and Nvidia Corporation ( NVDA ), means that its declining top-line directly impacts its bottom-line due to higher fixed costs. As a result, Intel's EPS has been on a downward trajectory, with a CAGR of -36.6% from 2020 to 2023. To stay competitive, Intel is aggressively investing in multiple areas, leading to a significant deterioration in the company's margins and a sharp decline in free cash flow.
The company's worsening financial situation has forced Intel to cut its dividends by approximately 23% to $1.12 per share annually. However, we believe Intel's dividend payout ratio remains well above the company's cash flow generation capabilities, potentially leading to further reductions in dividends or increased debt to fund the payouts. Intel's net debt position is also projected to deteriorate, limiting the company's financial flexibility and potentially raising concerns among investors.
Valuing Intel at this stage is challenging due to its deteriorating financial metrics and the uncertainty surrounding its ability to recover its competitive strength and future earnings. Examining valuation multiples, Intel currently trades at 40 times next 12-month EPS and 10.7 times enterprise value to forward 12-month EBITDA, suggesting potential overvaluation based on these metrics.
Conclusion
While Intel Corporation faces significant financial challenges and a weakening competitive position, the potential for a recovering China to provide pricing tailwinds offers a glimmer of hope. The company's ability to capitalize on this opportunity and maintain margins amid an increasingly competitive landscape will be critical for its future success. Investors should closely monitor Intel's performance and consider the company's valuation in light of both the challenges and potential growth catalysts from China's economic resurgence. After analyzing Q1 earnings and careful consideration, we have not changed our views on Intel Corporation and will maintain our Sell rating.
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Intel Q1: Margins Woes, But Can China Save The Day?