There can be no doubt that Intel has been a great business. Whether it can continue to be one is by no means certain.
Great companies only make great long-term investments if they stay great. A failure to defend a hard won position of competitive strength in an industry can leave investors frustrated and disappointed. This looks like the position that Intel (US:INTC) and its shareholders find themselves now.
One of the big lessons that investors have had drummed into them in recent years is the success they can have in buying the shares of great businesses. These are businesses that succeed by giving their customers what they want and doing it better than anyone one else.
By working hard to create a position of competitive strength – even dominance – and then growing revenues and profits, the gains in business value and the rewards to shareholders can mount up.
One of the golden rules in business economics is that high levels of profitability tend to attract competition. Understanding how a market leader maintains its position and why it might lose it is very important.
Intel, once the dominant player in the global microprocessing chip industry, is a fascinating study in how a market leader can lose its way, with valuable lessons for investors. It now seems to be at a tipping point. It has made mistakes and has lost a lot of its competitive strength. Can it get it back?
What made Intel great
For years, Intel was the world’s largest chipmaker. It developed the X86 architecture that formed the basis for the microprocessors that made up the central processing unit (CPU) that went into desktop and laptop computers.
It was the main beneficiary of Moore’s Law, which in simple terms refers to the number of transistors on an integrated circuit of a microchip doubling every two years. The company kept on making better performing chips compared with previous versions of its own products and that of its competitors.
This allowed it to dominate the personal computer (PC) chip market and build a business of massive scale. Its strategy of manufacturing as well as designing chips gave it huge scale economies and competitive strength.
The combination of dominance and scale created a very profitable and cash-generative business with significant pricing power. The huge profits it produced allowed Intel to fund a very large research and development budget that was many times bigger than its competitors and allowed it to defend and enhance its market-leading position.
If you were looking at Intel 20 years ago you could be forgiven for thinking that it looked unstoppable. However, the slowdown in its core PC market and a shift in technology has changed this.
Intel has been slow to adapt to a changing world and is arguably guilty of being complacent and milking its PC business for cash while its competitors got on with stealing the battleground from it. The company looks as though it has been hunted down and now has to turn itself into a hunter again to get back on track.
Why has it gone wrong for Intel?
A failure to innovate and capitalise on new trends
Intel has made a lot of mistakes in the past decade. Arguably one of the biggest ones has been to pull back from developing chips for the mobile devices market. The company initially targeted this market, but gave up on it. As people and businesses move away from doing things sitting at a desk to doing things on the move or on location, mobile devices have become the product of choice. Instead of the chip market for these products being captured by Intel it has gone to other companies such as Qualcomm (US:QCOM) and ARM Holdings.
The loss of production leadership
One of Intel’s biggest strengths was its ability to design and manufacture the best chips and bring them to market.
The quality of chips is weighed up by looking at how much power they offer relative to their size. The trend has been for the latest chips to be smaller while offering more power than their predecessors. Chip size is measured in nanometers (nm) and Intel has made some big errors in producing smaller chips.
It was slow to release its 10nm chip and is now around a year behind schedule with its release date for 7nm chips. This has seen the company cede its market leadership to Taiwan Semiconductor Manufacturing Company (Tai:2330), which has its 7nm chips on sale and could even move to 3nm chips in the next few years.
Investors rightly worry that Intel is a long way behind TSMC and may not be able to catch up. In the meantime, TSMC is busy making its superior chips for Intel’s competitors.
What may be even more worrying is Intel’s admission that it may have to outsource chip production given its current problems of getting new products to market. Its vertical integration (design and manufacturing) has been seen as one of its key competitive strengths and losing it may weaken it.
The rise of Nvidia and the resurgence of AMD
While some of intel’s current woes appear to have been self inflicted. There can be no doubt that its competitors have really upped their game and stolen a march on it.
The most notable is Nvidia (US:NVDA), which used to be seen as a niche player making high-end graphics processors for video gaming devices. Nvidia has taken the technology of its graphical processing units (GPUs) and applied it to fast-growing applications such as the data centers used in cloud computing and artificial intelligence.
Nvidia’s move to buy ARM will give it exposure to mobile technology and also possibly put it into a position to threaten Intel’s desktop and laptop markets. It is possible that a combination of Nvidia and ARM could create a one-stop shop for a variety of chip applications that no-one can currently match.
A real worry for Intel is that an Nvidia/ARM combination will be in a great position to exploit the current and growing trends in technology uses and the chip demand that comes from them.
Edge computing is a big theme, where the storage and use of data increasingly needs to be close to where it is being used rather than being sent back to another remote location. This and the internet of things (IOT), where lots of devices are connected to the internet and talk to each other, arguably favours the likes of Nvidia and ARM with their positions in mobile chip technology and artificial intelligence built in.
Advanced Micro Devices (US:AMD) had been competing with Intel for a long time without much success, but now seems to have taken a big step up with its product offer. The concern for Intel now is that AMD’s chips are much better and considerably cheaper than its own and not just in the PC market. Alphabet's (US:GOOGL) Google is using AMD chips in its cloud data centres, while Microsoft (US:MSFT) and Amazon (US:AMZN) are also using a lot of them these days. Will big PC companies such as Dell and Lenovo do the same?
Both Nvidia and AMD just concentrate on chip design and have outsourced production of their chips to Taiwan Semiconductor. This makes sense as they are not in a position to match Intel’s scale economies. Instead, they have focused on innovation and making great products, and are having a lot of success.
Big customers are designing their own chips
It seems that there are customers who no longer need Intel. Apple (US:AAPL) has dumped Intel and is designing its own chips to use in its Macbook computers using ARM technology. Amazon is also using ARM.
Big customers that would have previously turned to Intel for their chip needs may now choose to design their own using someone else’s technology and get TSMC to produce them.
Intel should not be written off just yet
Intel is clearly facing a lot of difficulties right now and resembles a wounded giant, but it is far from dead. It still has immense scale and financial strength that can be put to good use.
It is developing new artificial intelligence technology for use in areas such as autonomous driving. It also has some good products to sell into 5G mobile networks.
The company’s data center business is performing really well, with revenue growth of 43 per cent in the year to date. However, its PC business, with the exception of notebooks, looks to be ex-growth. The company is still able to push through price increases in its PC business, which in a different world might be seen as a sign of strengt,h but could now be seen as a bad thing given the growing strength of AMD.
Are Intel shares a classic value trap?
Intel’s problems are very well known. As a result, its shares now look to be extremely cheap compared with its competitors. The company also still scores very well when looking at key financial performance ratios such as operating margin, return on operating capital employed (ROOCE) and free cash flow margin.
For those of you who are familiar with Joel Greenblatt’s Magic Formula, which tries to identify businesses with high returns on assets combined with a cheap valuation, then Intel shares – on just over 10 times forecast one-year earnings – look very attractive right now.
Intel vs competitors
R&D as % of sales
Mkt cap $bn
One year rolling PE(F)
Source: FactSet/Investors Chronicle
The main drawback with the Magic Formula approach is that it ignores the vital ingredient to achieve good investment returns from owning shares: the ability of a company to grow. This is where the investment case for Intel seems to fall down at the moment.
Free cash flow
With its production problems and fierce competitive backdrop, it looks as though there is very little growth to come from Intel over the next couple of years. Yet the company is still expected to produce prodigious amounts of free cash flow and arguably doesn’t need to grow much to justify its current stock market valuation.
However, without some kind of positive newsflow, I struggle to see what drives the shares higher from its current level. There also has to be a real concern that its competitive position continues to weaken.
Technology shares have been running hot for a good while now, but Intel is proof that they still have to face up to the same strategic and competitive issues as other businesses. Intel’s loss of dominance is also a stark reminder to investors that great businesses need to work hard and smart to stay that way. Owning a share of a business that fails to do this is unlikely to do them much good.