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Morningstar | Multiple Near-Term Headwinds Don’t Dissuade Our Positive Thesis on Intel; Shares Undervalued. See Updated Analyst Note from 24 Jan 2019

Intel reported fourth-quarter results that fell modestly below our expectations, mostly due to a $200 million shortfall in modem demand from Apple, as well as softer demand in China, a digestion period in the cloud, and a tepid NAND environment. While these near-term headwinds will likely persist for a few quarters, we believe the 7% sell-off in Intel shares during after-hours trading was overdone. Management projected 2019 revenue will still grow, albeit only slightly. Nevertheless, given the macroeconomic weakness, U.S.-China tensions, and competitive pressures from AMD, we view this forecast as reasonable. With Intel’s 10-nanometer Ice Lake PC processors on track to be in OEM systems on shelves for holiday 2019 and the firm’s data-centric growth engine firing on all cylinders, we see an attractive margin of safety in this wide-moat chip titan relative to our unchanged $65 fair value estimate.

Fourth-quarter sales grew 9% year over year to $18.7 billion, thanks to growth across nearly every business segment with the exception of the Internet of Things group. PC-centric revenue rose 10% as notebook and desktop ASPs rose 6% and 13%, respectively, thanks to a richer product mix skewed to the likes of gaming. Following three-straight quarters of over 20% year-over-year growth, data center group sales grew only 9% for the quarter, due to softer China demand and cloud deceleration. Within DCG, 24% cloud segment growth and 12% communications service provider growth was partially offset by a 5% decline in enterprise sales. Positively, Xeon average selling prices were up 5% year over year, as cloud and enterprise customers alike move up the stack due to more compelling features.

Intel’s Internet of Things group fell 7% year over year, but when excluding Wind River, which the firm divested in the second quarter, Internet of Things sales grew 4%. Within Internet of Things, Mobileye sales grew 43% thanks to ongoing ramps of ADAS design wins. We expect Mobileye to continue driving stellar growth, as it won 28 new designs with 78 vehicle launches with its Eye Q processors in 2018. By the end of our explicit forecast period (2023), we think Mobileye can contribute nearly $3 billion in annual revenue to Intel’s top-line. The firm’s memory business grew 25% thanks to data center SSD growth and Optane persistent memory adoption. However, we think weak NAND pricing severely capped further growth during the quarter. Although NAND is a volatile business, Intel’s focus on high-value data center opportunities for its memory business is consistent with the firm’s strategy to develop high-value platform solutions in the data center as opposed to standalone components.

Programmable systems group (Altera) revenue rose 8% year over year thanks to strength in data center and communications, consistent with commentary from Xilinx. While arch-rival Xilinx recorded solid double-digit data center growth for its December quarter, Intel’s data center PSG business grew 50% year-over-year. Gross margins fell 430 basis points sequentially to 60.2%, due to a less favorable product mix and 10-nm-related costs. Despite Intel’s foray into high-growth margin-dilutive areas (that is, memory and Internet of Things), we note the firm has been able to achieve significant operating leverage to drive operating margins from 24.9% in 2016 to 32.8% in 2018.

In 2018, total revenue grew 13% to $70.8 billion. The firm’s data-centric strategy had an impressive year as it grew 20% versus PC-centric sales up only 9%. Despite the aforementioned near-term headwinds, management expects first-quarter sales of $16 billion (flat year over year) and 2019 revenue of $71.5 billion (up 1%), with data-centric sales up in the mid-single digits and PC-centric sales down in the low-single digits for the year. Concerning the latter, we assume a weaker PC market, some competitive pressure from AMD, as well as feeble modem demand for Apple’s iPhone. Nonetheless, given the challenging macroeconomic backdrop, we find it impressive that Intel can achieve modest revenue growth when its core PC-business is down. The positive offset isn’t coming solely from DCG, either, as cloud customers enter a period of consumption (we assume the first-half of 2019) following strong purchasing behavior throughout the first nine months of 2018. DCG VP Navin Shenoy highlighted that Intel’s latest Cascade Lake Xeon processors with superior AI and memory capabilities are now shipping and should contribute to stronger DCG performance in the back half of 2019. For the full year, capital expenditure is projected to be $15.5 billion, which bodes well for the wafer fab equipment space.

For more information on our thoughts on Intel and Mobileye, please see our recent Technology Select Presentation: “Autonomous Driving Fuels Our CES 2019 Public and Private Company Takeaways.”