15 April 2007

INTC: What to look for Tuesday

On Tuesday, semiconductor manufacturer Intel (INTC) will report its earnings for quarter ending 31 March 2007. In this post, we will identify the data we will check first to determine how well the company performed. We lack sufficient information to estimate how the first quarter results will change Intel's scores on our gauges, but we will address the factors that will move the scores the most.

We will publish a full analysis, with updated gauges, as soon as practical after Intel issues their report.

But, first, some background.

We saw little to foretell a recovery, after a Worst-in-the-Dow 2006, when we analyzed Intel's financial results, through December of that year. The share price continued to decline in the first quarter of 2007, from $20.25 to $19.13, but it is now back over $20.00. Recent improvements might be due favorable reviews given to Intel's newest products and predictions that Intel will regain market share from steadfast competitor Advanced Micro Devices (AMD).

Revenue. Intel's sales dropped in 2006 from $38.8 billion to $35.4 billion. Yes, revenues in the final two quarters of 2006 were greater than in the first two quarters, but this is almost always the case. If anything, the comparisons with 2005 worsened over the course of the year. For the first quarter of 2007, we're assuming, with little conviction, revenues of $9.27 billion. [The Wall Street estimate is $9.01 billion, but the predictions vary from $8.7 to $9.5 billion. This seems like a wide range for such a highly followed company] Our estimate would represent a 4 percent increase over the first quarter of 2006, but it would also translate into a 7 percent decline based on year-over-year comparisons. We chose the value we did with the thought that 2006's 9 percent year-over-year decline might have been the bottom, given Intel's improved competitive standing.

Operating expenses. Intel's gross margin declined from percent values in the upper 50's to below 50 as it fought for market share with AMD. We're looking for 51 percent in the latest quarter, which would translate into a cost of sales of $4.54 billion if the revenue estimate above were to be achieved. We will view a gross margin at, or above, our 51 percent estimate as a key sign of a turnaround.

Intel has not cut R&D and SG&A expenses to match the revenue decline. They probably feel that they have to continue to spend to beat back AMD's challenge. We've assumed 16 percent and 17 percent, respectively, of revenues for these two operating expenses. Given our revenue estimate, these percentages would translate into expenses of $1.48 and $1.58 billion.

Intel always seems to have other operating charges related the amortization of acquisition-related expenses, and, last year, there were big charges for restructuring and asset impairment. We have no visibility into what these expenses might be in 2007. Some companies try to get non-recurring "special" operating charges over all at once, so perhaps the worst is over. We're assuming $80 million of these expenses in the first quarter, which is about the average of the last 10 quarters.

Using the aforementioned estimates for revenue and operating expenses, we calculate a predicted operating income of $1.59 billion.

Other income. Net interest and other income had been running around $150 million per quarter, before jumping markedly in the last two quarters of 2006. The footnotes to the financial statements indicate that this was due to gains of $612 million from three completed divestitures. We will assume that the divestitures are over and, therefore, that $150 is a reasonable estimate for net income and other income in the first quarter. We're also assuming no gains on equity securities.

These assumptions lead to an income before taxes estimate of $1.74 billion.

Net income. The income tax rate has average about 30 percent, which would result in net income of $1.22 billion ($0.21 per share). The professional analysts are assuming $0.22 per share, give or take a couple of cents. [We're not sure which, if any, non-recurring gains and losses are built into the Street estimate. One has to be very careful using published EPS values.] In the year-earlier quarter, net income was $1.36 billion ($0.23 per share).

Valuation. To assess value, in keeping with our normal practice, we're using the 31 March stock price of $19.13. Taking the estimated net income for the first quarter of 2007, and combining it with the actual net income for the three previous quarters, the trailing 12-month P/E ratio will be about 23. This a little below the 26 average for the semiconductor industry, but it still constitutes a significant premium relative to the S&P 500. The premium, for a company with declining earnings, suggests optimism for a turnaround. Price/Sales is about 3.2, which is less than the 4.4 industry average. With decreasing earnings, the PEG ratio isn't meaningful.

Balance sheet. We've only written about the income statement to this point. But, given the Intel's recent performance, we view the inventory figures on the balance sheet as critical indicator of the company's financial health. Inventory/CGS was a too-high 92 days at the end of December, compared to 72 days in December 2005. The latter value is closer to the 5-year median. Finished goods were 39 percent of inventory at the end of December, which was the highest percentage of the current decade. Increases in this ratio sometimes indicate that a company's output has gotten ahead of demand.

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