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Intel Corporation (INTC)

Intel was incorporated in 1968 and is the largest manufacturer of semiconductor chips in the world. Intel’s primary products are microprocessors and chipsets.

A microprocessor acts as the brain of computers and many other electronic devices (e.g. servers, tablets, phones, wearable devices). It essentially controls and manages what a computer does by handling communications between the processor, memory, and other components.

A chipset consists of numerous electronic components that help manage the flow of data within an electronic device (e.g. between the mouse, keyboard, monitor, and hard drive; help balances the performance of a system).

The microprocessor and chipset are arguably the two most important factors that impact the performance and functionality of personal computers (PCs).

Intel’s customers are primarily equipment manufacturers in the computing and communications industries.

Desktop and notebook computers accounted for 55% of Intel’s sales last year but have been shrinking as a percentage of overall mix as PC demand continues to gradually decrease in favor of tablets and smartphones.

The remaining 45% of Intel’s business comes from data center processors (31% of Intel’s overall sales), flash memory chips used for computer storage needs, and other chips that improve the computing performance of electronics in cars and other devices and equipment, including many Internet of Things applications. These businesses are enjoying strong double-digit growth, driven largely by gains in data-centric businesses. 

Importantly, chips used in servers are much more profitable than those used in PCs. As a result, Intel’s operating profits are split almost evenly between its PC business and all of its other operations, led by data center processors.

Business Analysis

Intel’s microprocessors are used in over 80% of global PCs sold each year, according to Bloomberg, and the company has close to 100% market share on the $16.5 billion market for server chips that run instructions called x86 that power almost all commercial software, according to Mercury Research.

How has Intel amassed such a dominant share in these huge markets?

Simply put, Intel has consistently invested to maintain the most advanced manufacturing process in the world, enabling it to deliver the best performance and value proposition to customers.

Developing and manufacturing microprocessors is extremely complex and capital intensive.

The manufacturing process requires hundreds of steps in “cleanrooms,” which, according to Intel, contain air which is 1,000 times cleaner than a hospital’s operation theater. Building a single plant costs roughly $5 billion today and will only increase in cost going forward.

Research and development costs are also astronomical in the semiconductor manufacturing industry. Intel spent more than $137 billion on R&D in 2017, representing about 21% of its total sales, for example.

To maintain its technological lead, Intel must constantly invest in cutting-edge processes to improve the performance and value of its chips.

The company expects capital spending to total $14 billion in 2018, and Intel has spent more than $170 billion on R&D and capital expenditures since 2005.

Not surprisingly, there are very high barriers to entry in this industry. The cost of developing valuable intellectual property and building out competitive production facilities is enormous, especially when the bulk of customers are already dependent on Intel’s chips.

Intel’s investments have allowed it to historically introduce the next generation of process technology every two to three years, improving the performance of its chips at a breakneck pace that competitors cannot afford to keep up with.

Intel is also one of the few semiconductor companies that manufacture products using their own facilities (most semiconductor businesses design their chips and outsource manufacturing to save costs and generate more predictable cash flow).

As a result of its scale and vertical integration, Intel exerts more control over its performance optimization and can introduce new products to the market at a faster pace.

With costs to build leading-edge manufacturing facilities rising (it becomes increasingly difficult to build smaller chips), fewer companies are able to compete with Intel’s advancements in performance, energy efficiency, and cost.

In addition to spending on manufacturing plants and R&D, competitors and new entrants must contend with the strong reputation of Intel’s brand, which recently ranked as the world’s 15th most valuable brand.

Altogether, Intel’s economies of scale, leading technology portfolio, and cutting-edge manufacturing processes have created a powerful ecosystem with high switching costs for customers.

Intel’s architecture has been refined for decades, and the company has funneled well over $100 billion dollars to continue improving it.

As the incumbent technology in PCs and data centers, Intel’s processors have effectively locked up customers.

For example, when Dell develops a new computer, there is no compelling incentive to switch to a different processor family as long as the previous version worked and the next one offered by Intel is even better. Many legacy applications run on Intel’s technology, and switching would be costly in many cases.

Inertia is often a powerful factor in these markets as well, making it even more difficult for a real challenger to Intel to emerge.

As the industry’s giant and only viable supplier in many cases, Intel has largely controlled the pricing of its chips and can exert pressure on Advanced Micro Devices (AMD), its only competitor in PC microprocessors.

As seen below, Intel’s market share has risen significantly over the last 10 years at the expense of AMD.
Source: CPU Benchmark
With less scale than Intel and a weaker technology portfolio, there is little AMD has been able to do to compete. In response to Intel’s pressure, AMD actually spun off its manufacturing business in 2009 in an effort to improve profitability.

However, AMD is making some renewed efforts to gain share in the PC market, as you can see from the slight uptick in its 2017 market share in the chart above.

In an attempt to take back market share in high-end chips for the PC and servers markets, AMD is launching its Ryzen Threadripper processor to which Intel responded by announcing its new Core i9 brand. To retain its leading position in the PC market, Intel will also be revamping its core architecture (x86 processor).

Intel’s leading PC technologies have also provided the foundation for the company’s expansion into the data center and “Internet of Things” (IoT) markets.

Intel’s PC business provides an incredible scale with more than $33 billion of revenue and possesses substantial intellectual property that translates over into other electronics such as servers.

This gives Intel an advantage once again over smaller players with inferior manufacturing processes. However, it doesn’t guarantee Intel’s success in dominating these markets either.

Given a slowdown in the PC total addressable market, Intel is shifting from a PC-centric focus to a data-centric focus with more than 40% of total revenue now coming from data-centric businesses, which are growing at a double-digit clip. Solid growth in Intel’s data center operations is expected to continue.
Source: Intel Investor Presentation
The company’s top four priorities going forward are growing its data center and adjacencies businesses, ensuring a strong and healthy PC business, growing IoT and devices, and flawless execution in memory and field-programmable gate arrays (FPGAs).

One move Intel made to strengthen its position in data centers and IoT devices was its acquisition of Altera for $16.7 billion in 2015. This deal helped Intel gain exposure to FPGAs, a more flexible type of semiconductor chip that could account for as much as a third of the processors in all data centers by 2020.

By purchasing Altera (now known as Programmable Solutions Group), Intel can stay in front of this potential development and deliver customizable, integrated products that help improve data center operators’ performance and power efficiency.

Intel architecture is also becoming the preferred solution for the network transformation to SDN, NFV, and 5G, and the company should benefit from a pipeline of new product launches planned this year such as Skylake for data center, 64-tier 3D NAND SSDs, and extensions to its Optane product line.

In a bid to further diversify away from PCs and enter the autonomous vehicle market, which is expected to reach $100 billion by 2030, Intel agreed to acquire Mobileye for $15.3 billion in 2017.

This Israeli company is a leader in developing camera-based software for autonomous driving, and the combined company will be able to also provide sensors and processing and communications systems. Intel has signed a memorandum of understanding with automobile giants BMW Group and Fiat Automobiles to develop an autonomous driving platform, and the business reported 30 design wins in 2017 (up from 12 in 2016) with 27 OEMs.

Intel’s acquisitions and organic expansion efforts have significantly expanded its addressable market well beyond PCs, as you can see below.
Source: Intel Investor Presentation
When combined with management's cost-cutting efforts to reduce expenses from 35% of revenue to 30% by 2020, Intel seems likely to remain a cash cow for a long time to come, even if the PC market deteriorates further and data center growth slows.
Source: Intel Investor Presentation

Overall, Intel’s scale, world-class manufacturing processes, long-standing customer relationships, massive intellectual property portfolio, early-mover advantage in PCs, and strong reputation for quality have helped it essentially monopolize the market for PC processors.

The company is using its advantages in the PC market to extend into data center processors, which it also dominates, and is trying to crack into Artificial Intelligence and Internet of Things devices to continue its long-term growth.

While it will likely take years to evaluate the success of Intel’s major acquisitions of Altera and Mobileye, as well as the company’s increased push into more data-centric applications, where competition is fierce, Intel is certainly a force to be reckoned with.

Key Risks

Most recently, Intel spooked investors when news came out in early January 2018 that the company's chips had two major security flaws, which opened the door for data to potentially be stolen from Intel-based computers and servers. 

Intel quickly rolled out software patches to address the problem, although its solution was noted to cause some performance-related disruptions in some instance. For now, the company doesn't expect the issue to impact its financial performance, and Intel's greater-than-expected revenue guidance for 2018 seems to back that up.  

Otherwise, it's worth noting that the world has changed a lot since Intel incorporated 50 years ago.

For one thing, computers were extremely rare and largely unavailable to the public. The first microprocessor didn’t even exist until 1971.

Today, computers are everywhere, and relatively new devices such as tablets and smartphones are beginning to erode total demand for Intel’s legacy cash cow – PCs (around 50% of operating profits). If demand falls faster than expected, Intel’s profits could struggle to grow.

Recent data from IDC showed that global PC shipments fell by close to 1% in the third quarter of 2017, suggesting that PC headwinds remain gradual but aren’t likely to abate any time soon.

Intel benefited for many years from the rapid ascent of computers, which drove strong demand for its microprocessors. However, the company is now relying on other growth drivers to remain competitive, especially if the market for PCs contracts faster than expected.

As noted earlier, Intel is performing well data center processors and expects to benefit from the market growing to $65 billion by 2021. The company is also working to capture a meaningful market share in artificial intelligence and a broad array of IoT devices.

Intel is leveraging the scale and intellectual property from its legacy PC business, but that certainly doesn’t guarantee its success in gaining a strong and profitable market share in these emerging, fast-growing industries.

Intel’s push into these industries is also pitting it against competitors and threats it didn’t previously face in the PC market.

Perhaps most notably, cutting-edge tech giants such as Facebook, Apple, and Google have increasingly expressed a desire to make their own chip designs and leverage other suppliers to push back on Intel’s pricing.

They are well aware of the monopoly profits enjoyed by Intel and increasingly view hardware as a performance differentiator, increasing the incentive to develop their own intellectual property and processes. Intel already has a large custom chip business, but it’s worth remembering this risk factor.

The biggest competitive threat to Intel’s data center processor business, which is responsible for driving the far majority of the company’s profit growth, is arguably ARM Holdings.

ARM uses a different architecture than Intel and currently dominates the smartphone market, which relies on smaller chips.

Unlike Intel, ARM is a chip designer that makes money from licensing and doesn’t do any manufacturing. ARM also has a strong financial backing now, after being acquired by the Japanese multinational company Softbank.

ARM has already launched chips for data center servers, challenging Intel’s major profit driver. It’s hard to imagine that these chips will be able to match Intel’s high level of performance, but it’s worth mentioning that Microsoft is already showing interest in the ARM-based data center.

Qualcomm (QCOM), who makes chips for smartphones, also produced its first computer server chip designed to compete with Intel’s most important business last year, and Nvidia’s graphics chips are increasingly being used in artificial intelligence applications.

Here is what Bloomberg noted about some of these developments:

“This isn’t the first time ARM manufacturers have taken aim at the server market. Other chipmakers have promised computer components—based on the ARM technology that dominates in mobile phones — that would loosen Intel’s stranglehold, yet none have done so. That may be changing this year as Qualcomm, one of the few companies that can rival Intel’s spending on research and design, begins offering its first server processor and as other chipmakers finally field long-promised chips that are capable of competing.”

For now, Intel’s incumbency and performance advantages in data center processors seem hard to uproot, but pressure is certainly building.

Growth in the server chip market can perhaps serve as a rising tide that lifts all boats and helps Intel deal with the continued decay in PCs. Alphabet, Amazon, and Microsoft spent more than $31 billion on data centers in 2016, up 22% from the previous year, according to The Wall Street Journal.

For now, Intel has continued driving growth from its core Client Computing Group (CCG) and Data Center Group (DCG). However, the company needs to keep increasing revenues from its Non-Volatile Memory and IoT groups as well to mitigate any possible risk of a faster than expected decline in the PC market.

Another risk factor to note is that semiconductor technology is constantly evolving. Microprocessors become faster and more powerful each year while also shrinking in size and cost.

While Intel is one of the only companies with the financial strength and reputation to invest in the best manufacturing processes and R&D, the pace of chip improvements has begun to slow in recent years as the physics of chips has become extraordinarily complex.

If innovating in performance and power becomes increasingly difficult, the competitive gap between Intel and its competitors could begin to narrow. Intel could also begin to realize a lower return from its multibillion-dollar investments.

Finally, Intel’s substantial acquisitions of Altera and Mobileye over the last two years create risk. These two deals are by far the largest in the company’s history, and the price tag was certainly not cheap; Intel paid around 140 times earnings and more than 42 times total sales for Mobileye, for example.
It will likely take years to assess the success of these mega deals, which hinge on a number of assumptions made about fast-changing markets. If the future plays out differently than management expects, Intel will be left with less flexibility to adapt.

Closing Thoughts on Intel

While Intel has historically dominated the PC and data center markets, which have helped the company pay uninterrupted dividends since 1992, the computing world is undergoing broad changes.

Rapid growth in the cloud, data consumption, and connected devices bodes well for many of Intel’s business lines, but such fast growth, combined with Intel’s dominant market share and excellent profitability, is also attracting many old and new competitors.

Investors seem more worried about profitable growth prospects in Intel’s high-margin data center business than they are about the continued erosion of the PC market, and it’s hard to fault them given the importance of this business as a growth driver and the high amount of uncertainty surrounding the dynamic competitive landscape.

For now, Intel’s massive investments in factory equipment, manufacturing processes, and R&D have helped it largely stay ahead of its rivals to enjoy healthy pricing power and high margins.

The company’s large acquisitions of Altera and Mobileye could also help it capitalize on new areas of profitable growth while strengthening its existing data center operations, but they also come with substantial risks.

While Intel needs to continue its dominance in the server chips market and capitalize on its recent acquisitions to mitigate falling demand for PC processors, the stock should continue to serve as a reasonable source of safe income with moderate growth for a diversified dividend portfolio.

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