October 15, 2003
Book On Intel’s Impressive Quarter Being Repeated in 4Q03
But don’t bank on INTC’s stock price appreciating faster than ROE
By Brady Willett

Equity Breakout

Despite the downturn in technology spending, Intel has continually reported profits instead of losses.  However, and ignoring yesterday’s results for the moment, Intel has been unable to sustain any increase in shareholders’ equity for more than three years (Intel had $35.5 billion in net equity as of June 30, 2003 versus $36.1 billion on April 1, 2000). Accordingly, you could say that all of the earnings generated by Intel since April 2000 were not really ‘earnings’ at all.  Rather, the $100.6 billion in ‘profits’ reported over the last fourteen quarters were Intel’s cost of doing business – Intel’s cost to simply maintain its balance sheet net worth.

Suffice it to say, the trend of Intel’s profits being used to sustain balance sheet integrity did not last for fifteen quarters.  Rather, thanks to added technological efficiencies, and strength in emerging markets, Intel was able to generate ROA of 3.53% in the quarter ended Sept 27, 2003 – compared to ROA of 5.6% for the quarter ended April 1, 2000 – and this was enough for the company to stop its balance sheet from bleeding red.


After a Two Year Slump, Annualized ROE Rebounds

“Sales in Asia excluding Japan grew 31 percent from the same quarter last year to $3.27 billion, accounting for 42 percent of Intel's revenue. Sales in Japan grew 73 percent to $716 billion…” Bloomberg

Notwithstanding the above typo – which if correct would mean that every Japanese consumer now owns 20 Pentium powered computers - Intel’s financial results for the quarter ended September were nothing less than fantastic.  Yes, usually when I use a word like ‘fantastic’ to describe a ‘better then expected’ quarterly report from a company like Intel it is to speak satirically. However, this is not the case today.

In order to better understand why Intel’s results are superlative, consider a return-on-equity chart (to note: all recently released financial statistics on Intel, and some of the historical data attached in the following Excel file, are unaudited). What this chart tells us is that the company is no longer hemorrhaging equity. Quite frankly, this news alone – irregardless of revenues, earnings, and margins - suggests that Intel is fully prepared to profit from any further upturn in technology spending.  I apologize if this statement makes me sound like an overly optimistic Wall Street analyst. Nevertheless, after watching and ridiculing near dividendless companies like Intel for abusing their balance sheets in recent years, news that Intel added nearly $2 billion in equity last quarter! is certainly worth applauding.


Why is it important that a company post ROE gains?

The balance sheet – even if CNBC guests rarely mention it - is the most important of the three financial statements.  To be sure, all of the earnings and cash flows in the world don’t amount to much of anything if the balance sheet is not holding its own (the exception being that companies with high dividend yields may be doing great even if they simply keep their balance sheet stable). In short, think of the balance sheet (tangible equity) as representing what a company is actually worth, and the income statement as being the fabricated lies the excitable investing public follows in earnest because the balance sheet can rarely be regarded as ‘sexy’.

As for investor’s that don’t think balance sheets’ are important nowadays – what with Cramer and company seemingly having reacquired their prescient gut feelings - they should remember what happened to Intel’s stock price back in 2000. Despite signs of softening tech demand and a top in the Nasdaq, Intel shares soared for most of 2000. However, in the fourth quarter of 2000 – after 2Q00 and 3Q00 quarter over quarter ROE gains had already begun to slump – the company posted a decline in Q-o-Q equity.  What happened to Intel’s stock price once ROE stopped rising by leaps and bounds? Lets just say that using the term ‘bloodletting’ would be a gross understatement.
 

Put another way – one day Intel shareholders are happy paying more than 11 times book value, and 10 quarters later they are only willing to pay 3 times book (INTC’s stock price fell by more than 80% during this time).  This form of stock price carnage is why buying high p/b stocks can be dangerous – companies can continually report profits, but if ROE stops growing p/b premiums will usually contract if starting out from ‘high levels’.  Incidentally, and for the sake of simplicity, anything over a p/b multiple of 1 can be ‘high’ for a company that is not growing equity or paying a respectable dividend.

More ROE Gains Ahead?

In each of the last three years IDC, Gartner and Wall Street have predicted an upturn in tech spending, and with the exception of this year these forecasts have proven inaccurate. Suffice it to say, all that can be known with regards to tech trends is that the tech replacement cycle is not as short as many once thought it was, and most technology companies do not – and may never again – have the ability to consistently raise prices at will (remember, it is a more efficient Intel that is generating ROE gains today, not an Intel that releases a new chip and then doubles prices).

Intel notes strength in domestic consumer markets and emerging markets, but states that domestic business spending has shown little sign of improvement. Will U.S. companies spend a great deal more on IT next year?  Was the upsurge in domestic consumer spending a one-time event due to Bush’s back-to-school tax rebates?

Regardless of speculation, some historical stats suggest that Intel will post positive financial improvements in the near term: with the exception of the year 2000, Intel has reported its strongest quarterly revenues and net margins in the fourth quarter of each of the last 6 years. This may suggest, baring the unexpected, another solid quarter of ROE gains in 4Q03, or before what will be a crucial 1Q04 (or when Intel updates investors on the company’s capital spending plans for 2004, and after other companies finalize their 2004 spending budgets).


Conclusion

Currently trading at more than 7 times price/sales and 5 times price/book, Intel is certainly not a stock for the safety minded investor.  Quite frankly, and unless the company is embarking upon another 1990s type growth phase, Intel’s stock price will continue to see volatility – both to the upside and downside – as quarter to quarter growth rates fluctuate and/or as the broader U.S. stock markets rally, correct, or crash.  Trying to time this volatility can be exceptionally dangerous.

As for the investor considering purchasing Intel as a long-term investment, it should be pointed out that even if the 1990s do return that Intel is still not a risk free investment. On the contrary, using the quarterly reports from March 28, 1998 to September 2000 Intel averaged roughly 6.5% in quarter to quarter ROE (*paying no attention to growth in intangibles).  Even if you extrapolate this supercharged figure into the future, it would still take nearly 7-years before Intel’s book value neared its current market cap.  A lot can happen in 7-years…


By way of comparison, if you use the last 22 quarters as a guide – or include both the good, and bad times in your forecast – it would take more than 16-years for Intel’s book value to reach its current market cap.  This is truly shocking, and is one of the reasons you can conclude that the bubble is back: assuming a respectable 2.6% quarterly ROE, or 10.4% annual ROE, it would take more than 16-years for Intel’s book value to reach its current market cap. An awful lot can happen in 16-years…

In sum, given that Intel just posted its first annual increase in equity in the last 9-quarters, yesterday’s ‘better than expected’ report was truly better than expected.  Nevertheless, realizing that the actual worth of a company is found in the balance sheet, INTC’s stock price remains a dangerous income statement gamble, not a safe balance sheet investment.  For the long-term investor that fully understands the industry, owning a leader like Intel may be a more palpable consideration when, and if, the company’s share prices dips below 3 times book value.

BWillett@fallstreet.com

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