RealMoney Silver - INTC Still a Value, but Momentum Has Gone

INTC Still a Value, but Momentum Has Gone
By Bill Trent
RealMoney.com Contributor
1/23/2008 12:48 PM EST

In October, I wrote a bullish article suggesting that Intel (INTC) had all its ducks in a row. Up until the earnings report this week, the stock was performing more or less in line with the S&P 500. Now, however, it is looking like a bad call.

In hopes of figuring out what went wrong with my thesis, I took a fresh look. I still believe Intel is worth buying at these prices, but I would probably wait for a signal that momentum was returning to the name before starting a new position.

One mistake was in accepting what I realized were somewhat aggressive estimates. "According to the Semiconductor Industry Association, the year-over-year sales growth for the industry has ranged from 1.7% to 4.8% over the last six months. For the largest manufacturer to be growing at more than twice the overall industry rate seems somewhat aggressive at first glance," I noted.

I thought that "since Intel and rival Advanced Micro Devices (AMD) were the first companies to over-order, the first to see the damage it did to their margins, and the first to announce cuts to planned expenditures, it should surprise nobody if they are the first to recover as well." Compared with most semiconductor makers that was true, but it was not enough to justify a double-the-industry growth rate.

I also thought the worst would soon be over in semiconductor pricing trends, but things have managed to get worse in the meantime. That said, the industry's capital spending discipline remains intact: Data released yesterday showed that orders for semiconductor equipment were down more than originally reported in November and down 18% year-over-year in December. As demand gradually catches up to supply, pricing power will improve.

To my credit, I was correct about Intel and AMD seeing a recovery sooner than the overall industry. I noted that "margins for both AMD and Intel are lower than they have been at any time since the depths of the technology bust. A modest improvement from current levels would still leave them well below the normal range, if there is such a thing." Intel's margins improved from 52% in September to 58% in the December quarter.

I was also correct to point out improving inventory trends at Intel. Inventory levels declined $132 million sequentially and nearly $1 billion from the December 2006 quarter. Inventory reductions tend to put a damper on margins, so once the excesses are depleted, margins should improve further. The inventory reductions also provide a significant (though temporary) boost to cash flow.

You didn't think I'd write a whole article without coming around to cash flow, did you? But why not? Cash flow is probably the single best reason to consider owning Intel right now. Over the past 12 months, Intel's free cash flow (cash from operations less capital expenditures) was $7.2 billion, for an effective free cash flow yield of more than 7% on the current enterprise value.

Intel has been letting this cash pile up on its balance sheet in cash and marketable securities that are probably yielding just 3% or 4%. To me it would be a no-brainer to buy the company's stock and increase that yield to 7%. I suspect that a $7 billion buyback announcement, to be executed promptly, would put some mojo back into the shares.

In the meantime, no matter how much of a value Intel seems to be, the momentum is clearly gone. I would probably want to wait for investors to start recognizing some of the value before jumping in here. Though I am not a technical analyst, measures such as the MACD signal or a close above the 50-day moving average would probably qualify. Alternatively, fundamental momentum in the form of positive earnings revisions could also count.

Another option would be to get paid for waiting by selling out-of-the-money put options. The July $17.50s were selling for $1.25 at the time of writing. That would provide a 7% six-month return on the money at risk and an effective entry point of $16.25 if the option is exercised.