The market reacted poorly to Intel’s (INTC) Q3 earnings report. I think that presents an opportunity.

What did I think about INTC and AMD last time I wrote?

Not quite 15 months ago, I wrote the previous article in my series comparing the operating performance of Intel and Advanced Micro Devices (AMD). Since that time, shares of INTC have gone up and down in price and are about at the same place they were when that article came out late in August 2019. Meanwhile, shares of AMD have more than doubled, starting at a price of around $28 and now trading over at $85.

Also at the time of that article, Intel was projecting revenue of $69.5 billion and EPS of $4.40 for the year. AMD was projecting revenue growth of low single digits. Each company had had a hard opening quarter in 2019 but did much better in the second quarter.

Figure 1

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(Source: Author’s calculations)

My buy under price is very much determined by the dividends I expect to receive and not by where I expect the market to move the price. My buy under price here of $44 was predicated on getting $1.30 in dividend payments over the next four dividends. INTC actually paid $1.305 a share over that period.

Before I look at what is new for INTC, let’s look at AMD

To be a reliable investment partner, I want management to be able to predict future performance with a reasonable level of accuracy. So once again, we will first look at how AMD saw Q3 2020 when it was presenting results for Q2.

Figure 2

(Source: AMD Q2 Results)

The guidance for Q3 looked pretty good, and AMD managed to bring in revenue in the upper half of its predicted range. That is pretty good. Revenue growth is very substantial, but the growth in operating income is very impressive. Back in 2019 and even earlier, AMD did struggle to produce operating profits, and these results show that that the struggle is now largely won.

Figure 3

(Source: AMD Q3 Results)

AMD does include gaming sales in with data center sales, but it is still pretty impressive (particularly when looking at Intel’s results in the data center) that the company racked up both revenue and operating income gains in its Enterprise, Embedded, and Semi-Custom segment. An increase of over 300% is impressive, no matter how you slice it. In Q2 2019, AMD had operating income of $59 million, which was $173 million a year later and is now up to $449 million. Revenue started at $1,531 million and is now at $2,801 million. These results show that AMD is finally putting some real pressure on Intel.

What did the latest earnings report say about Intel?

The first step in analyzing how Intel did this quarter is to look back at how management saw the year and this quarter when last they reported earnings.

Figure 4

(Source: INTC Q2 Earnings Presentation)

Clearly, management didn’t see 2020 as some sort of blockbuster. While management projected revenue for the year to go up, they were expecting only a modest 4% growth in revenue and flat EPS. With the 10nm process now producing production chips, they are ramping down the CAPEX spending that was required to make that happen.

Figure 5

(Source: INTC Q2 Earnings Report)

Q3 clearly looked like a challenging quarter in an otherwise modest growth year. Management was projecting that data center revenue would be down, but only modestly. Looking back a year, the Q2 projections for Q3 were $18 billion in revenue, so part of why Q3 looks so weak this year is due to how strong Q3 turned out last year.

Figure 6

(Source: Intel Q3 Earnings Presentation)

The market reacted quite negatively to this earnings report, but looking at the information presented, Intel modestly increased its guidance for the year. Sure, a $300 million increase in revenue guidance isn’t much for Intel, but it is $300 million. And bumping up EPS 5 cents a share isn’t a bad thing either. The big disappointment is that the operating margin declined more than projected. While the miss is small, even small misses could become a problem when margins are under pressure.

Figure 7

(Source: INTC Q3 Earnings Presentation)

Again, in the quarterly numbers, we see a miss on margin. This is partially offset by the penny beat on EPS. The miss on margin looks to have been larger driven by a bigger decline in data center revenue, which has a much higher margin, compared to PC-centric sales. Since EPS is down a lot (and that is only partially due to how good Q3 was last year), let’s drill down on that number.

Figure 8

(Source: INTC Q3 Earnings Presentation)

While Intel did sell more chips, the big hit came from lower prices and higher costs. The 10nm chips simply cost more to make at this time. We have been looking for an impact on Intel from the AMD Zen architecture chips, and we haven’t found it until now. Lower prices are, at least in part, the result of comparable AMD chips being on the market. And likely that AMD has its own line of GPUs is also a factor in both cost and volume. Intel’s GPUs (DG1 and DG2) have yet to prove themselves.

Now let’s look at how the two big segments fared this quarter.

Figure 9

(Source: INTC Q3 Earnings Presentation)

The Client Computing Group is where Intel tracks its sales for PCs, both the more traditional desktop and the notebook (what was once called a laptop). This quarter saw a big swap from desktops to notebooks. Part of this was driven by more people working from home and part from notebooks just being more popular now that they are even more capable. Despite increasing revenue from last year, margin compression resulted in lower operating income. A large part of this is due to the change in the product mix. However, I don’t think we can ignore that part of this is likely due to competition from AMD. AMD faced the same product mix issues, and it was able to grow both revenue and income. Going forward, we will need to keep an eye on whether Intel can lower the costs of producing chips for notebooks so that it stops this margin compression.

Figure 10

(Source: INTC Q3 Earnings Presentation)

The results from the Data Center Group are what sent share prices down after this report came out. This group has in the past been by far the most profitable for Intel, so the margin compression here was taken as a very bad sign by the market. But the profit margin was so high because there was very little competition for Intel in this segment. The Epyc chips ended this situation, and so, it was only a matter of time before margins would come down as long as AMD kept delivering. Intel will need to keep improving the yield and lowering the cost to produce the chips that customers want.

What’s a good price?

To figure out a good price, I use a DDM calculation using my Excelbased DDM calculator (pictured below – you can see the web-based calculator I based it on here and read a discussion on how the formulas were developed here). I also found this discussion of DDM, and note that in the article the author uses a discount rate of 5%. Over the years, I have modified the calculator so that it will more closely model the dividend streams from companies I am interested in investing in.

Looking at David Fish’s CCC List (which contains data on companies that have raised their dividend each year for 5 or more years), I see that since I last wrote about Intel, it has rejoined the CCC list. In prior articles, I have used a dividend growth rate of 5% for Intel, and the CCC list gives the 1-year CAGR of the dividend growth as 5%, so I will continue to use that. I will also continue with the 3% terminal dividend growth rate. Intel is expected to raise the dividend payment for next year in the next payment, but to be conservative, I will calculate the dividends for the next 12 months using only a penny increase. That gives me a dividend payment of $1.36.

Figure 11

(Source: Author’s calculations)

Using those parameters, along with my standard expectation of growing my income at a 6.4% rate (twice the rate of inflation since 1913), I calculate that the NPV (Net Present Value) of the expected dividends is $45.10. That gives me a buy under price of $46. On Monday, November 10, INTC closed at $45.60, making it a good buy.

What to watch for going forward?

First, let’s look at the guidance for the rest of the year.

Figure 12

(Source: INTC Q3 Earnings Presentation)

While this doesn’t point to a stellar year, who thought that 2020 would turn out to be one anyway? Intel is projecting a modestly up year. In part, this is due to a very good first half, but it is still an up year. Pressure on the margins is the big thing to watch for in the near future.

Figure 13

(Source: INTC Q3 Earnings Presentation)

Q4 has a tough comparison from last year. While COVID-19 gave Intel some nice tailwinds in the first half of the year, it has been (and looks to continue to be) a bit of a headwind in the 2nd half of the year.

The other big things to watch from Intel are the progress of the 10nm and 7nm processes. Last quarter, the company indicated a problem with the 7nm. Given all the issues in developing 10nm, this gave the market some serious concerns. In the conference call, Bob Swan stated that the 7 nm process was making wonderful progress and that they had deployed a fix for the issue identified last quarter. The 10nm based chips were ramping up even faster than expected.

Conclusion

Intel did not have a disastrous Q3, despite how the market reacted. In fact, the company modestly exceeded guidance from the beginning of the year. Much of the supposed disaster was based on inflated expectations from the first half of the year, when COVID-19 provided the company with a big tailwind.

One good thing about the market’s reaction to the Q3 results is that the price is finally below my buy under price. Intel is now trading at a good value. Many years after I sold my share at a very nice profit, I might be able to get back in again.

As a dividend growth investor, I like INTC. For those who don’t require dividends and want good capital gains potential, AMD is looking to be a very good choice.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in INTC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.