QUIC RESEARCH REPORT. Technology, Media & Telecom. Intel Corporation (NASDAQ: INTC) Leader in Semiconductors Offers Value in New Markets

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1 QUIC RESEARCH REPORT Technology, Media & Telecom David Del Balso Shun Yao Josh Morris Adam Klingbaum Intel Corporation (NASDAQ: INTC) Leader in Semiconductors Offers Value in New Markets Introduction - The QUIC TMT portfolio currently does not have direct exposure to the semiconductor industry, and we believe Intel would be an excellent company to add to the portfolio. - The semiconductor industry has recently been hit by declining demand from PC end markets, but has a bright outlook in the automotive, industrial, and communications markets. There will be continued M&A activity in this industry. - Intel is the leading designer and manufacturer of microprocessors, and is therefore able to achieve scale and maintain bargaining power over customers. - Intel is uniquely positioned to capitalize on growth ahead in its Data Center Group segment and in new markets in which it is making investments. - Intel trades at a discount to its peers on several valuation multiples. Based on trading comparables and a DCF, we have established a price target of $39.30 for INTC, which would generate an all-in return of 14.14%. - This report will dive deeper into the semiconductor industry and Intel as a company and an investment candidate. QUIC Research Reports focus on emerging investment themes that affect current portfolio companies and companies under coverage. The information in this document is for EDUCATIONAL and NON-COMMERCIAL use only and is not intended to constitute specific legal, accounting, financial or tax advice for any individual. In no event will QUIC, its members or directors, or Queen s University be liable to you or anyone else for any loss or damages whatsoever (including direct, indirect, special, incidental, consequential, exemplary or punitive damages) resulting from the use of this document, or reliance on the information or content found within this document. The information may not be reproduced or republished in any part without the prior written consent of QUIC and Queen s University. QUIC is not in the business of advising or holding themselves out as being in the business of advising. Many factors may affect the applicability of any statement or comment that appear in our documents to an individual's particular circumstances. Queen s University 2016

2 Table of Contents Industry Overview and Outlook 3 Industry Overview and Outlook 6 Investment Thesis I 8 Investment Thesis II 9 Investment Thesis III 10 Catalysts and Risks 11 Discounted Cash Flow Analysis 12 Comparable Companies Analysis and Valuation Summary 13 References 14

3 Industry Overview and Outlook Semiconductors A semiconductor is a solid substance that can carry a level of conductivity greater than that of an insulator but less than that of a conductor. Semiconductors are crucial components of the electronic circuits that are used in all sorts of technology because the properties of a semiconductor allow it to control the state of a component in a circuit with minimal voltage. Since the introduction of this technology, semiconductors have created a $54.2 billion market in the U.S. Types of Semiconductors Semiconductors can be grouped into four main categories: 1) Memory chips: store temporary data and pass information; major players are Toshiba, Samsung, and NEC. 2) Microprocessors: integrated circuits that carry out all functions of central processing unit in a computer; Intel dominates this segment, though AMD still remains a player 3) Commodity Integrated Circuit: standardized chips that perform basic processing; this segment is occupied predominantly by large producers in Asia 4) Complex System on a Chip: integrated circuit chip combining an entire system s capability; this segment offers the highest growth potential for players Major Players The two major players in the U.S. semiconductor industry are Intel and Samsung, though many other smaller players exist, including Texas Instruments, Advanced Micro Devices, Qualcomm, and NVIDIA. EXHIBIT I Major Player Market Shares U.S. Intel leads the semiconductor market as a whole. EXHIBIT II Industry Revenue and Growth The industry took a hit when PC sales began to drop. 14.7% 100,000 80, % 10.0% 11.4% 60, % 3.5% 40,000 (10.0%) 70.4% 20, E (20.0%) (30.0%) Intel Samsung T.I. Other Revenue YoY Source: IBIS World Source: IBIS World 3

4 Industry Overview and Outlook (Continued) Industry Characteristics After growing almost non-stop for 40 years, the semiconductor industry has seen signs of revenue slowing over the last few years with average selling prices to end markets decreasing. The industry can also be characterized by perpetual technological innovation, primarily driven by Moore s law, a phenomenon that states the number of transistors on a single chip will double every two years. The optimization and scaling of production processes has allowed this phenomenon to sustain itself. Lastly, the industry can also be characterized by the intensive capital requirements to maintain growth and continue augmenting technological processes. Many semiconductor companies, including Intel, are global leaders in research and development, but R&D in this industry can often be risky due to the amount of time that may exist in between the designing, manufacturing, and actually bring a chip to the market. Sales in the industry are highly driven by end-market demand for electronics, including laptops, tablets, and mobile phones. The decline in the demand for personal computers has been a significant challenge for industry players, who are now trying to grow their other revenue sources to offset the weak personal computer environment. Foundry, Fabless, and IDM Companies competing in the semiconductor industry typically take on one of two operating models foundry or fabless. Foundry companies operate solely in the manufacturing of chips. The largest foundry in the U.S. is IBM. Fabless chip makers take on the design and marketing of chips, but outsource the manufacturing of them. Fabless semiconductor companies include Advanced Micro Devices, NVIDIA, and Qualcomm. Intel is known as an Integrated Device Manufacturer (IDM), as it designs, manufactures, and sells its integrated circuit products. EXHIBIT III Average Selling Price for Semiconductor Devices Average selling prices are beginning to stabilize, but will likely face a perpetual decrease. Source: PriceWaterhouseCoopers 4

5 Industry Overview and Outlook (Continued) M&A in the Semiconductor Industry As revenues in the industry have slightly slowed, companies have looked to M&A activity to expand into emerging markets with growth opportunities. Given the competition in the industry, companies have also been using M&A activity to gain market share and achieve scale, which can gives certain companies advantages in their design and production life cycles. Outlook While average selling prices in the industry are expected to continue getting squeezed by end segments and applications, revenue growth in the industry will likely only remain in the low-to-mid single digits, and profitability will be tough to maintain with increasing fab costs, process development costs, and chip design costs. Going forward, the industry will be dominated by large EXHIBIT IV Annual Semiconductor Deal Volume ($MM) M&A remains a major component of the industry. 25,059 players who can achieve scale and pricing power over suppliers and end market customers. Depending on the demand coming from the PC market, winners in the industry will also be able to generate revenue from other end markets. The most promising growth opportunities in the industry lie within the automotive, industrial, and communications end markets, while the consumer and computer segments show signs of mature markets. Companies will continue to engage in M&A activity to find growth and profitability in the promising end market segments. Across the three promising market segments automotive, industrial, and communications there also exists an opportunity for semiconductor companies to produce chips enabling the Internet of Things, which could likely be a big turning point for the semiconductor industry. EXHIBIT V Five-Year Growth Rates by Sub-Segment Automotive, Industrial, and Communications lead. 11.2% 7.3% 7.2% 17,380 8,102 10, % 0.4% Source: PriceWaterhouseCoopers Source: PriceWaterhouseCoopers 5

6 Company Overview Business Overview A designer and manufacturer of advanced integrated digital technology platforms, Intel is a leader in the semiconductor industry. Each Intel platform consists of a microprocessor and a chipset, as well as any additional hardware, software, and services that serve to enhance the platform. Intel s platforms are based upon a lineup of nine microprocessors: (1) Intel Quark Processor, (2) Intel Atom Processor, (3) Intel Pentium Processor, (4) Intel Celeron Processor, (5) Intel Core m Processor, (6) Intel Core i Processor, (7) Intel Xeon Processor, (8) Intel Xeon Phi Processor, and (9) Intel Itanium Processor. Intel sells its platforms to original equipment manufacturers, original design manufacturers, and industrial equipment manufacturers in computing and communications markets. Intel s platforms are incorporated in the world s leading commercial and personal technological devices, including notebook EXHIBIT VI Intel Stock Price Relative Performance Last Twelve Months Intel has outperformed the S&P 100 the last twelve months. 130 and desktop computers, servers, tablets, mobile phones, and Internet-of-Things-enabled devices. Intel s offerings also span to software and services. Moore s Law This company s strategy revolves around its effort to continue pursuing Moore s Law. Gordon Moore, the co-founder of Intel, observed in 1965 that the number of transistors per square inch on integrated circuit doubles every two years. Intel continues to persistently pursue this phenomenon in order to maintain its leading position in the semiconductor manufacturing industry. Top Share Ownership 1. The Vanguard Group, Inc.: 6.33% 2. BlackRock Institutional Trust Company: 4.16% 3. State Street Global Advisors: 4.00% 4. Capital World Investors: 3.53% 5. Capital Research Global Investors: 3.53% Aug Oct Dec Mar May Aug-16 NASDAQGS:INTC S&P 100 Index Source: Capital IQ 6

7 Company Overview (Continued) Operating Segments Intel s business activities are grouped into six segments: 1) Client Computing Group (CCG): All Intel platforms designed for notebook and desktop computer, 2-in-1 devices, tablets, and mobile devices. It also includes wireless and wired connectivity products and mobile communication components. 2) Data Center Group (DCG): All platforms that offer leading performance for enterprise, cloud, communications infrastructure, and technical computing markets. 3) Internet of Things Group (IOTG): All platforms engineered for applications in retail, transportation, industrial, and home and buildings markets, among others. 4) Non-Volatile Memory Solutions Group (NSG): All NAND flash memory platforms used in solid-state drives. 5) Intel Security Group (ISecG): Security software for computers, mobile devices, and networks. 6) Programmable Solutions Group (PSG): Programmable semiconductors and related items designed for a variety of market; formed in 1Q16 as result of Altera acquisition. Acquisition of Altera In 1Q16, Intel acquired Altera Corporation, a global designer and seller of programmable semiconductors and related technology, for total consideration of $14.5 billion. This acquisition will expand Intel s reach to new classes of platforms. EXHIBIT VII FY 2015 Revenue Breakdown by Segment DCG now makes up a larger portion than it ever has. 4% 5% 4% 29% 58% CCG DCG IOTG SSG Other EXHIBIT VIII Key Intel Professionals Andy D. Bryant (Executive Chairman): Previously EVP of Tech, Manufacturing, and Enterprise Also worked at Ford and Chrysler MBA in finance from University of Kansas Brian M. Krzanich (Chief Executive Officer): Previously served as Chief Operating Officer Has served various other roles at Intel since 1994 Bachelor s in chemistry from San Jose State University Stacy J. Smith (Chief Financial Officer): Joined Intel in 1998 and has held positions in finance, sales & marketing, and information technology MBA in finance from University of Texas Paula Tolliver (Chief Information Officer): Joined Intel in August 2016 Previously CIO at The Dow Chemical Company Bachelor`s in Computer Science from Ohio University Source: Company Report Source: Capital IQ 7

8 Investment Thesis I: Market Leader with Scale Advantage Intel has defended its leading position in the semiconductor industry for several decades. As the word s largest semiconductor IDM, they are the preferred choice of microprocessor for the world s leading designers and manufacturers of computers, mobile devices, servers, and now autonomous vehicles and Internet-of-Things-enabled devices. Intel s leading position has been established through their heavy investments in research and development and their relentless effort to continue to keep up with Moore s Law. As the exponential growth suggested by Moore s Law becomes harder to achieve as time goes on, Intel is becoming recognized more as the one company that can keep pace with this phenomenon. Intel s leadership in the market gives them points of attraction for a QUIC investment that other players in the industry do not have. Firstly, it gives them a scale advantage, which means they can manufacture chips and platforms at lower costs than competitors. In the declining ASP environment of the semiconductor industry, Intel is able to use this advantage to increase its operating margins, as it has done in the past. Their leadership also gives them bargaining power over buyers, making them less sensitive to the declining average selling prices in the industry. As well, being a leader in the industry, with an industry-leading R&D budget, also means that Intel can position itself in new markets with high growth potential than other smaller players in the industry. As a leader in semiconductors, Intel retains the business of the Super 7 : Google, Amazon, Facebook, Microsoft, Baidu, Alibaba, and Tencent, all for whom Intel makes custom chips with special features. Intel has a dominant position in the industry, and the above mentioned competitive advantages make this position sustainable. EXHIBIT IX Some of Intel s Customers for Whom it Makes Custom Chips Source: Company websites 8

9 Investment Thesis II: Value in Data Center Segment Intel s Data Center Group (DCG) designs and manufactures platforms for enterprise, cloud, communication infrastructure, and technical computing markets. This segment has become a greater portion of Intel s revenue as the company has strived in recent years to focus less of their business on the personal computers market. This segment has realized impressive growth, and grown at 12% compounded annually. The year-over-year growth of the DCG segment in Intel s 2Q16 fell short of the company s target. Senses of investor uncertainty and pessimism about this segment were likely priced into the stock, implying the full potential of this segment is valued at a discount. However, management s commitment to continue driving growth in this segment could lead to low double-digit year-overyear growth for the next few years. The higher margins in the DCG segment will also contribute directly to Intel s bottom line. EXHIBIT X Intel DCG Annual Revenue ($MM) Intel has grown their DCG segment 12% annually. Intel s management has made clear their dedication to driving growth in DCG on account of: (1) growing Cloud demand, (2) their ability to penetrate the networking market, and (3) their position to capitalize on the artificial intelligence market. With regard to the Cloud, as a market leader with a 99% share in the enterprise server market, Intel is well positioned to drive growth from increasing Cloud demand with the ability to produce units at an unparalleled scale. Speaking to networking, his market is estimated as an $18 billion total addressable market with customers transitioning to standardized silicon chips, photonics, and fabrics. Intel can capture this market with its new generation of Xeon chips and Omni-Path Fabric. With regard to artificial intelligence, Intel has been gaining momentum in this emerging market with efforts in deep learning. Intel is capturing market share with its Xeon Phi chips and its strengthened partnership with Baidu s deep speech initiatives. EXHIBIT XI Intel s Virtuous Cycle of Growth These market segments feed each other s growth. 14,387 15,977 10,129 10,741 12, Source: Company Report Source: Company repot 9

10 Investment Thesis III: Well Positioned for New Markets Intel s leaders have strongly emphasized their goal to move beyond personal computers and gain share of new markets. The efforts concentrated in their Data Center Group have been a large component of this, but the company has extended their efforts to investing in other new markets, namely autonomous driving and the Internet of Things. The semiconductor industry has been challenged by the declining revenues from the personal computer market, and Intel s investment in these other areas, and their ability to gain more share than competitors, will be a contributing factor to Intel offsetting declining PC revenue better than its competitors, implying reason for Intel to be valued higher than its peers. Autonomous Driving The emerging market in autonomous driving yields opportunity for growth in the semiconductor industry. Intel is uniquely positioned to become the dominant manufacturer of semiconductors for this market segment due to its end-to-end approach that can address the vehicle, network, and cloud components of autonomous driving. Intel s Xeon and Xeon Phi are able to handle the inference and training aspects, while their offerings in 5G and optical connectivity can address the networking component. Then, Intel s software is able to mesh all these systems together. Intel s unique end-toend offerings for autonomous driving give the company an excellent position to capitalize on this emerging market. At the beginning of July 2016, Intel entered a partnership with BMW Group and Mobileye to develop solutions for fully automated driving. BMW selecting to partner with Intel is a clear testament to Intel s leadership in the semiconductor industry, and the opportunities that lie ahead for Intel in autonomous driving leave much room for valuation expansion and make Intel an attractive investment. EXHIBIT XII Estimated Global Installed Base of Cars with Self-Driving Features Source: Business Insider Intelligence Estimates

11 Catalysts and Risks Catalysts 1) Order from Apple: In June of 2016, a rumour entered the market that Intel will be supplying modem chips for the versions of Apple s next iphone on AT&T s U.S. network and some other networks overseas. Representatives of both companies decline to comment on the matter, but if Apple were to give Intel this order, it would be the first major score for an Intel mobile chip and would take share away from Intel s biggest competitor in the mobile space, Qualcomm. Cowen and Company estimates this order could generate $1.5 billion of revenue for Intel, leading to $850 million of operating profit. This deal could also open up a whole new relationship between Apple and Intel and possibly open up more opportunity for Intel to make share gains in the tablet and smartphone end markets. 2) Acquisition of Altera: At the end of 2015, Intel acquired Altera Corporation, a leading provider of field-programmable gate array technology. This acquisition was made in an effort for Intel to compete in the programmable semiconductors market segment. This deal added an entirely new operating segment to Intel s business and will drive a whole new source of revenue for the company. FY 2016 will be the first complete year of Intel reporting Altera s operating results, and if these results might be impressive enough to serve as a catalyst for Intel s stock price. 3) Launch of 10nm: Intel is expected to launch a new set of 10nm chips in The success of this release would show the global semiconductor industry that Intel is capable of keeping on pace with Moore s Law, claiming them as the leader of this market. The 10nm chip could also allow Intel to get more mobile and tablet wins. Risks 1) Greater than expected decline in PC: As previously mentioned, declining PC demand has been challenging companies in the semiconductor industry, including Intel. Revenue estimates for Intel take into account the weak PC market environment, which is expected to be offset by Intel s other revenue sources, including the high-growth Data Center Group segment and new revenue sources in the programmable semiconductors space. However, given that a large portion of Intel s sales is still linked to sales in the PC end market, the downside risk remains that PC sales could decline at a greater than expected rate, which potentially would not be offset by other sources of revenue. 2) Deceleration of Data Center segment: As Intel concentrates efforts toward moving away from the PC end market, they are investing heavily in growing their Data Center Group. If for reasons related to the enterprise cloud and networking end markets, Intel is not able to generate the growth it is expecting from this segment, it would be tough for Intel to offset revenues that it is losing in the tough PC environment. 3) Competition: Though Intel has remained a market leader in microprocessors for several decades, there does exist the risk of Intel losing market share to competitors like AMD. If Intel is unable to maintain its lead, its existing OEM and ODM customers may switch suppliers, causing Intel to lose market share to competition. 11

12 Discounted Cash Flow Valuation Discounted Cash Flow Model Historical Fiscal Years Projected Fiscal Years FY 2013 FY 2014 FY 2015 FY 2016 PF FY 2017E FY 2018E FY 2019E FY 2020E Total Revenue 52,708 55,870 55,355 57,846 60,738 64,383 66,314 68,303 YoY Change (1.2%) 6.0% (0.9%) 4.5% 5.0% 6.0% 3.0% 3.0% Cost of Sales (21,187) (20,261) (20,676) (21,317) (22,079) (23,082) (23,443) (23,805) % of Revenue 40.2% 36.3% 37.4% 36.9% 36.4% 35.9% 35.4% 34.9% Gross Profit 31,521 35,609 34,679 36,529 38,659 41,300 42,871 44,499 % Margin 59.8% 63.7% 62.6% 63.1% 63.6% 64.1% 64.6% 65.1% Operating Expenses (19,230) (20,262) (20,677) (21,382) (22,299) (23,476) (24,015) (24,565) % of Revenue 36.5% 36.3% 37.4% 37.0% 36.7% 36.5% 36.2% 36.0% Earnings Before Interest and Taxes 12,291 15,347 14,002 15,147 16,360 17,824 18,856 19,934 % Margin 23.3% 27.5% 25.3% 26.2% 26.9% 27.7% 28.4% 29.2% Income Tax Expense (2,991) (4,097) (2,792) (3,181) (3,435) (3,743) (3,960) (4,186) Net Operating Profit After Tax 9,300 11,250 11,210 11,966 12,924 14,081 14,896 15,748 YoY Change (13.6%) 21.0% (0.4%) 6.7% 8.0% 9.0% 5.8% 5.7% Plus: Depreciation and Amortization 8,032 8,549 8,711 8,173 8,278 8,453 8,375 8,167 % of Revenue 15.2% 15.3% 15.7% 14.1% 13.6% 13.1% 12.6% 12.0% Plus: Share-Based Compensation 1,118 1,148 1,305 1,330 1,387 1,460 1,494 1,528 % of Revenue 2.1% 2.1% 2.4% 2.3% 2.3% 2.3% 2.3% 2.2% Less: Capital Expenditures (10,711) (10,105) (7,326) (10,045) (10,547) (11,180) (11,515) (11,860) % of Revenue 20.3% 18.1% 13.2% 17.4% 17.4% 17.4% 17.4% 17.4% Change in Net Working Capital 3,140 (99) (1,081) Unlevered Free Cash Flow 10,879 10,743 12,819 12,415 12,255 13,086 13,656 14,052 YoY Change 33.5% (1.3%) 19.3% (3.2%) (1.3%) 6.8% 4.4% 2.9% Discount Period Discount Factor 96.4% 89.5% 83.1% 77.1% 71.6% Present Value of Unlevered Free Cash Flow 11,962 10,963 10,869 10,531 10,061 WACC Calculation Risk-Free Rate 1.54% Market Risk Premium 7.50% Beta 1.05 Cost of Equity 9.42% Pre-Tax Cost of Debt 3.25% Effective Tax Rate 21.00% Share Price Calculation PV of UFCF 53,700 Terminal Growth Rate 2.00% Discount Rate 7.71% PV of Terminal Value 148,873 Enterprise Value 202,572 Enterprise Value 202,572 WACC Terminal Growth Rate $ % 1.75% 2.00% 2.25% 2.50% 7.31% % % % % Cost of Debt 2.57% Less: Total Debt 22,748 Plus: Cash & Equivalents 15,308 Capital Structure: Equity Value 195,132 % Equity 75.00% % Debt 25.00% Shares Outstanding 4,800 WACC 7.71% Implied Share Price $

13 Comparable Company Trading Multiples Company Name Market Enterprise EV / EBITDA Dividend Price / Earnings EV / Sales Capitalization Value LTM 2016E 2017E Yield 2016E 2017E 2016E 2017E Intel Corporation $167,288 $178, x 8.3x 7.5x 3.0% 14.1x 13.1x 3.1x 3.0x QUALCOMM Incorporated $92,589 $87, x 10.1x 9.4x 3.4% 14.6x 13.2x 3.8x 3.7x Texas Instruments Inc. $70,225 $71, x 13.0x 12.2x 2.2% 21.8x 20.3x 5.5x 5.3x NVIDIA Corporation $33,386 $29, x nmf 17.5x 0.7% nmf 26.7x nmf 4.9x Advanced Micro Devices, Inc. $6,030 $7,311 nmf 121.1x 65.8x - nmf nmf 1.8x 1.7x Minimum $6,030 $7, x 8.3x 7.5x 0.7% 14.1x 13.1x 1.8x 1.7x 25th Percentile $33,386 $29, x 9.7x 9.4x 1.8% 14.4x 13.2x 2.8x 3.0x Median $70,225 $71, x 11.5x 12.2x 2.6% 14.6x 16.8x 3.4x 3.7x 75th Percentile $92,589 $87, x 40.0x 17.5x 3.1% 18.2x 21.9x 4.2x 4.9x Maximum $167,288 $178, x 121.1x 65.8x 3.4% 21.8x 26.7x 5.5x 5.3x Valuation Summary Target Share Price Calculation DCF Share Price $ % Median P/E 2016E $ % Median EV/Sales 2016E $ % Target Share Price $ Return Calculation Share Price ( Close) $ month Target Price $39.30 Dividend Yield 3.00% All-in Return 14.14% Our target price for Intel is an average of: (1) the implied share price from our discounted cash flow analysis and (2) trading multiples that we thing are fair to assign to Intel s operating metrics based on its comparable peers. On all trading multiples, Intel is trading at a discount to the median of its select peers. Given Intel s potential to grow revenue at a higher rate than its peers in the new markets it is entering, and its ability to scale operations and increase operating margins in an environment of decreasing average selling prices, we believe Intel should trade in line with 75 th percentile forward multiples. Given the slight uncertainty of the revenue growth Intel s DCG will generate and the uncertainty in the PC market segment, we instead assigned it multiples in line with peer medians. We arrived at a target share price of $ With Intel s 3.00% dividend, an investment in Intel would yield an all-in return of 14.14%. 13

14 References 1. Bloomberg 2. Business Insider 3. Capital IQ 4. Company Websites, Reports, and Press Releases 5. Deutsche Bank Securities 6. IBIS World 7. Jefferies 8. Morgan Stanley 9. PriceWaterhouseCoopers 14