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Morningstar | Choppy Near-Term Outlook Doesn’t Dissuade Our Positive Thesis on Intel; Shares Undervalued

Intel reported first-quarter results that were in line with expectations, while reducing its 2019 guidance $2.5 billion to $69 billion (which implies a 3% year-over-year decline). In hindsight, Intel’s prior guidance appears to be somewhat overambitious as it incorporated a substantial uplift in the second half, particularly from the data center group. Given the swath of challenges facing the semiconductor market (including but not limited to: PC CPU supply constraints, inventory builds in smartphones and GPUs, cloud inventory digestion, weaker China chip demand, and a tepid memory market), much of the recent recovery in semiconductor stocks seems premature, especially given the second-half recovery is not a foregone conclusion, in our view. We remain positive on major industry trends such as 5G, AI, greater semi content in automotive, shift to the cloud, and the broader "Internet of Things." Wide-moat Intel remains well positioned to capitalize on many of these burgeoning tailwinds with unmatched breadth in its product portfolio. Although some share gains are likely by rival AMD as it ramps up new offerings, Intel’s 10-nanometer products are on track for hitting shelves during the second half of 2019 with certain mobile Ice Lake variants to be qualified during the current quarter. Shares tracked lower by 7% during after-hours trading, but we think investors with a long-term horizon will find current levels compelling relative to our unchanged fair value estimate of $65 per share.

First-quarter revenue was $16.1 billion, flat year over year. Client computing group sales rose 4% thanks to a richer product mix led by gaming, as notebook and desktop ASPs rose 13% and 7%, respectively. We note the capacity constraints faced by Intel for PC chips (stemming from stronger-than-expected demand and Intel’s delayed 10-nm ramp) contributed to PC volumes being down 7% year over year.

The firm has been (rightfully so) focusing on higher-value products at the expense of lower-core offerings (which will likely lead to AMD share gains in the latter), but ongoing 14-nm capacity increases and the 10-nm ramp should mitigate this issue beginning in the third quarter.

Meanwhile, DCG sales fell 6% year over year as modest cloud growth (5%) was offset by weaker enterprise and government revenue (down 21%) stemming from an inventory correction. Cloud demand (particularly in China) is expected to further moderate in the second quarter, though CEO Bob Swan confirmed an improvement is expected in the second half of 2019. DCG operating margins (37.6% versus 49.7% last year) were negatively affected by lower sales, initial 10-nm costs, and increased roadmap investments.

Concerning Intel’s adjacencies, Mobileye sales were up 38% year over year, with eight new ADAS design wins during the quarter coupled with a major North American OEM adopting the firm’s Road Experience Management for crowd-sourcing mapping data. We continue to anticipate healthy double-digit growth from this subsegment going forward. Intel’s memory business, in contrast, faces severe conditions with pricing pressure leading to a 12% year-over-year decline and $297 million operating loss. This is one area that we think Intel’s new management will have to re-evaluate considering the massive investment needed to manufacture 3D NAND and 3D XPoint and volatile pricing dynamics that run counter to Intel’s high-margin PC and server CPU businesses. Though sales in the former Altera business fell 2% year over year, wireless revenue grew 30% thanks to early 5G deployments.

Gross margins for the quarter were down 400 basis points year over year to 56.6%, primarily because of initial 10-nm ramp costs flowing directly to COGS and losses in memory. Once these 10-nm Ice Lake products are qualified during the second quarter, however, these previously reserved units will sell through in the third quarter, thus bolstering margins (as the costs were already recognized). Consequently, while it is normal for margins to be lower during the initial ramp of a new process technology (TSMC faces similar margin headwinds to the tune of 100-200 basis points), the near-term margin headwind corroborates that Intel’s much-maligned and delayed 10-nm ramp is on track for products on shelves for holiday 2019. We expect Intel’s first-quarter gross margins to be the trough for the year. Regarding capital expenditures, Intel maintained its $15.5 billion target, which bodes well for wafer fab equipment suppliers.

Management expects second-quarter revenue to be down 8% year over year at $15.6 billion, with DCG sales flat sequentially and PC sales down high-single digits year over year. For the full year, DCG sales will be down in the midsingle digits while PC-centric revenue will be down in the low-single digits. Swan confirmed these declines were primarily driven by lower unit volume rather than ASP declines that could suggest more intense competitive pressures from AMD. Intel will be hosting its investor day on May 8, and we look forward to hearing from the new management team on their strategic endeavors.