Newsletter portfolio holding Intel (INTC) continues to change with the world around it. An increasingly smart and connected world offers significant opportunities for the company, but those opportunities will not be presented without obstacles to hurdle. It didn’t work out so well for the price of Intel the week of its report, as it released a somewhat cautious outlook on a day of a big market swoon, but we still expect some good things ahead from the chip giant. In fact, we continue to like the holding in the context of achieving the goals of the newsletter portfolios.
In the fourth quarter of 2015, results released January 14, Intel reported record revenue of $14.9 billion, though the top line grew a modest 1.3% from the fourth quarter of 2014. The Client Computing Group, which accounted for 59% of total revenue in the quarter, experienced a modest revenue decline as significant pricing strength was unable to offset volume declines of 16%. Intel’s Client Computing Group includes platforms designed for desktops, notebooks, tablets, and phones, among other devices. On a year-over-year basis, desktop platform volumes fell 9%, notebook platforms dropped 10%, and tablet volumes plunged 33%. The pressure on volume in this area continues to be expected, but we’re viewing the pricing resiliency as a significant “gross-margin-positive” event and a source of upside on a go-forward basis.
The Data Center Group, which includes enterprise and cloud-related platforms, has grown steadily as of late, and the fourth quarter was no exception. Revenue in the group advanced 5% in the quarter to $4.3 billion, a record for the segment, and it now accounts for nearly 29% of revenue. Worth noting in the group was cloud computing growth rates north of 40% on a year-over-year basis in 2015. Expansion in the Data Center Group during the quarter slowed on a year-over-year basis from the 12% leap in the third quarter of 2015 due to “macro weakness,” but we are quick to warn of the dangers of putting too much emphasis on any one period’s results. The same reasoning goes for the 4.1% quarterly decline in operating income in the segment ($2.17 billion versus $2.27 billion), even as we say we would have still expected segment profit growth, despite the slowing uptick in divisional revenue.
Intel’s Internet of Things (IoT) Group is expected to play a growing role in the company’s growth story moving forward, though its operating-profit contributions are marginal, all things considered. Nevertheless, the group saw its fourth quarter revenue grow to $625 million from the fourth quarter of 2014, an increase of 6%, which also represented a record for the segment. Though the division currently accounts for less than 5% of the firm’s total revenue, the impact of it on Intel’s growth story continues to increase. As with the Data Center Group, however, operating income dropped on a year-over-year basis in the fourth quarter, to $132 million from $177 million, revealing some weakness with respect to cost containment during the period.
Perhaps the most compelling growth story in 2015 for Intel was the 20% jump in its Memory business, where $2.5 billion in revenue was generated. Though pricing pressure is always a concern in fast-changing memory operations, Intel and Micron (MU) are preparing to launch into the market a new disruptive technology in 2016, the 3D XPoint nonvolatile memory technology, the industry’s first new memory technology in more than two decades. The 3D XPoint technology is said to have “up to 1,000 times lower latency and exponentially greater endurance than NAND.” See the video here. Despite collectively only accounting for ~40% of Intel’s revenue in 2015, the Data Center Group, the IoT Group, and Memory made up for more than 60% of the firm’s operating margin. The higher-margin growth opportunities in these businesses are the core of Intel’s strategy moving forward.
Though Intel beat expectations on a variety of metrics in the fourth quarter, it was hard to get too excited about consolidated performance. Revenue growth wasn’t great, gross margin at the company fell 1.1 percentage points, mostly due to higher unit costs and lower volume. Research and development and marketing, general, and administrative spending was higher than the firm expected in the quarter, and as a percentage of revenue, research and development and marketing, general, and administrative spending grew to 35% of revenue from 33% in the fourth quarter of 2014. The growth in spending Intel undertook in the fourth quarter caused operating income to fall 3% in the quarter to $4.3 billion. Earnings-per-share was flat on a year-over-year basis in the quarter.
Despite the somewhat lackluster fourth-quarter results, Intel remains a strong free cash flow generator. The firm generated ~$19 billion in cash from operations in 2015 while purchasing $7.3 billion in capital assets, resulting in free cash flow of $11.7 billion for the full year, an impressive 21%+ of revenue for the annual period. Though cash from operations declined from 2014 ($20.4 billion), a reduction in capital spending from north of $10 billion in the prior year helped free cash flow grow from $10.3 billion in 2014.
The nearly 14% jump in free cash flow helped the firm increase its cash and investments balance by more than $11 billion to $25.3 billion from the end of 2014 and compares favorably to the company’s $22.6 billion total debt level, which increased as a result of $9.5 billion in new long-term debt as part of its Altera acquisition financing plan. We have been huge fans of the Altera acquisition since it was announced:
By most estimates, the ASIC and ASSP replacement opportunity alone offers growth that’s twice as fast as the overall semiconductor industry, something Intel wants, and Altera brings to the table a complete FPGA portfolio (Generation 10), from the Max 10 (refresh CPLD/low-end) to the Arria 10 (mid-range markets), and the Stratix 10 on the high end. Altera estimates that the PLD (FPGA) market was nearly $5 billion in 2014, but the combined portion of the ASIC and ASSP markets that was accessible for PLD displacement was over $50 billion, revealing the tremendous growth potential of PLDs (FPGAs). Altera’s Stratix Series already cooperates with Intel 14nm Tri-Gate technology, offering customers double the performance gains in most cases. In a recent Intel presentation, the tech behemoth showcased the significant cost per transistor savings in its 14bnm TriGate technology. The new HyperFlex core fabric architecture results in a level of performance and power efficiency that is unmatched by any existing FPGA architecture, according to the firm.
We like Altera’s competitive position to win new business…with Intel, which should smooth deal integration. In fact, Altera’s management will tell you that its partnership with Intel has given it an upper hand in addressing performance, power consumption, and cost at the same time, while rivals have struggled with each sequentially. From what we can tell, this has given Altera an early-mover advantage, even relative to its chief FPGA rival Xilinx (XLNX), and the growing “process technology gap” for new designs between PLDs (FPGAs) and the ASIC alternative is revealing. Even if Altera doesn’t sustain such an advantage relative to technology-savvy peers, the benefits of FPGAs over ASICs should generate a market large enough for a number of players.
Altera will obviously play a key role in the future of Intel, and we’re expecting some big developments toward the latter part of this decade. Looking ahead to 2016, Intel is expecting revenue to grow at a mid-to-high single digit pace on both a GAAP and non-GAAP basis. Gross margin on a GAAP basis is expected to fall 1.6 percentage points, primarily due to non-cash acquisition adjustments related to the Altera transaction. Capital spending for the year is projected to increase to $9.5 billion, revealing the potential for a reduction in free cash flow in 2016, but Altera’s free cash flow contributions should move the needle (Altera is a cash-generating machine). Cautious comments on China (FXI), however, may mean management is being conservative with its outlook, and we certainly can understand.
All in, we continue to be fans of Intel–it is a holding in both newsletter portfolios–and its ability to continue generating strong free cash flow while its business evolves. A weak PC market will continue to weigh on its largest operating segment, but other growth opportunities are exciting from 3D XPoint to its deal with Altera to upside in mobile with Apple (AAPL). 2015 marked a year showcasing Intel’s evolving strategy, and 2016 remains a year of growth as the firm powers the infrastructure of an increasingly smart and connected world. Investors will be watching its growth story closely as they get paid along the way. An annual cash dividend of $1.04 per share translates into a 3.5% dividend yield.
Computers & Peripherals: EMC, MU, NTAP, SYNA, SNDK, STX, TECD, WDC, ZBRA
Semiconductor Equipment: AMAT, CREE, KLAC, LRCX, MKSI, SNPS, TER, UMC
Semiconductors – Specialized: ALTR, CRUS, LLTC, NVDA, MCHP, XLNX