16 Oct INVESTOR CORNER: Intel New Management Sets New Tone

Moor Insights & Strategy “Investor Corner” is content specifically written for the professional investment community.  This analysis was written by Steven Eliscu as part of Investor Corner, L-sq Advisors, October 16, 2013.  See important disclosures and disclaimers below.

At the recent Intel Developer Forum (IDF), Intel’s new CEO, Brian Krzanich and President, Renée James set a positive tone as they showed determination to win back the low-end computing market, which has been overshadowed by non-Windows tablets, a market where Intel processors have been largely absent. Intel also announced a new platform, Quark, for the Internet of Things market (where connected nodes communicate largely among each other, requiring a highly-efficient, low-power intelligent compute capability along with some type of wireless connectivity). Intel highlighted its near-term goal to get the Quark technology into the hands of developers and let them invent new ways of using it. Thus, even as Intel’s mea culpas for so badly missing the smartphone/tablet revolution were reassuring, the more significant change was Intel’s forward view as to how it plans to participate in the next wave of more ubiquitous computing. (Preliminary Quark specs suggest this product line will initially compete with products being served by ARM-based Cortex A-class processors and other equivalent 32-bit architectures and be in a category above 32-bit microcontrollers such as those based on the Cortex M-series as well as proprietary architectures from Atmel, Freescale, Microchip and Renesas.)

While this was encouraging, the backdrop of a declining PC market and slowing growth in servers makes it difficult to see how anything Intel can do short-term can positively move the needle on meaningful earnings growth. While some of Intel’s established end-market challenges may be cyclical, we are inclined to view them as more secular, as consumers’ first choice for a computing device is typically not a PC but rather a smartphone (along with a tablet, which largely mirrors the smartphone experience), and capital spending on IT hardware is likely to remain constrained for some time.

We acknowledge these challenges but also feel it is useful to focus on the potential earnings upside of the Bay Trail platform and highlight Chromebooks as an important category to watch. The analysis below shows potential EPS upside of 5% or more in 2014 if: 1) Intel’s substitution of Core processors for Bay Trail within the Celeron and Pentium brands supports margin accretion, 2) Intel can win significant designs in Android tablets.

A New Aggressiveness at the Low-end

The most noteworthy development at IDF was Intel’s stated aggressiveness to become a leading tablet processor vendor with its upcoming 22nm Bay Trail platform (and the 14nm Cherry Trail this time next year). Its processing performance leadership (as it showed benchmarks vs the Qualcomm Snapdragon 800 and NVIDIA Tegra 4) was not a surprise. Even as far back as May 2011, Intel presented a slide at its Investor Day projecting that the CPU performance increase of its 2013 tablet platform (Bay Trail) would be 3x (for the SPECint benchmark) vs its 2012 platform (Clover Trail).

We note the impressive performance of the Apple A7 processor suggests Intel’s performance lead vs the other ARM processor vendors could be short-lived as they are also implementing the ARM v8 64-bit instruction set architecture (ISA) in their next generation chips – likely to debut by mid-2014. Cited 2x CPU performance gains in the A7 have been in large part the result of the improvements in the ARM v8 ISA vs the 32-bit v7 ISA. This suggests other ARM CPU core implementations (in addition to Apple’s custom core), including ARM’s own Cortex A57/A53 cores, could also field impressive gains, especially as they should also gain the advantage of a full node shrink to 20nm.

The resistance to Windows 8 adoption, in large part the result of limited app support for Windows’ Modern User Interface, remains a major challenge for Intel to grow its tablet market penetration. However, with Android as a tablet operating system gaining largely at the expense of Apple’s iOS, Intel has a viable avenue for the tablet market, albeit with stiff competition that is largely absent in the Windows world. Intel’s ability to penetrate Samsung (where it has a toehold with a win on the latest Galaxy Tab 10.1), Asus, Google and Amazon, will likely be a big determinant of its success over the next year. The likely inclusion of Apple’s 64-bit processor in its next generation iPads could be an extra impetus for Android OEMs to choose Intel’s 64-bit Bay Trail, even if advertising its 64-bitness is purely a marketing exercise near-term.

At IDF, Intel showed particular enthusiasm to be a leader among the Shenzhen tablet ODMs, although we hardly believe this will be a major driver for Intel, as it will need to compete against the increasingly advanced Allwinners and Rockchips of the world. Again, the 64-bit card could allow Intel to pick off the top of this market, but it is hard to imagine Intel wants to sell too many decapitated dual-cores to hit the $10 processor price range (at least initially) when high-end versions of Bay Trail (for tablets) should fetch $25-30. However, we should not count out Intel’s new desire to push down market, and with a cost-optimized single-core version of Bay Trail in the future, perhaps Intel could get its die size under 50mm2 and silicon cost sub-$5. Still, this suggests that Intel would barely be making much gross profit at all on a finished product level. Presumably, Intel would not be selling very many of these chips unless it also sold to those same ODMs quad-core Bay Trails at $25 where gross margin should be closer to the 50% range.

Yes, Bay Trail in the tablet market is likely to be gross margin dilutive – that should be no surprise, and Intel has indicated all along its focus on driving increases in gross profit dollars (knowing full well that its continued success in server chips should help it to maintain its 60% mid-point corporate average goal). To at least partly offset this dilution from tablets, Intel also will be selling Bay Trail into desktops and notebooks branded as Celeron and Pentium (note that at least some percentage of Celerons and Pentiums will still be based on Haswell as with the recently introduced Dell Inspiron 11 and Acer C7 720). With expected average selling prices in the $30-50 range for those chips and potentially 30M units of Bay Trail sold into the notebook and desktop market (~10% of PC volumes) in 2014, Intel should be able to minimize margin dilution.

If the PC versions of Bay Trail (i.e. Bay Trail-M for notebooks and Bay Trail-D for desktops) cost $15 to make and are sold for $35-40, Intel would realize a ~60% gross margin, essentially in line with corporate average. Intel has made the point that in the PC market, Core-based versions of Celeron and Pentium are below-average margin devices, and the substitution with Bay Trail should be margin accretive.

For example, if Intel’s cost on the Core-based Celeron and Pentium is $25, its gross profit for substituting Core with Bay Trail should rise by $10 x 30M = $300M. This would translate to a $0.04 adder to its 2014 EPS (assumes 100% fall-through to operating profit, 26% tax rate, 5.1B shares). In reality, Bay Trail-based Celerons and Pentiums will likely be sold at some discount to those based on Core, so the estimated accretion may be less, but it is still likely to be material, as Intel historically has positioned its processor brands to fit within particular price bands, which is unlikely to change a lot with Bay Trail. A sensitivity analysis covers potential outcomes that range from a penny to an 11 cent EPS adder:

Table 1: Sensitivity of Intel EPS Adder: Bay Trail-M/D Gross Profit Adder vs Core, Number of Bay Trail-based PCs

Gross Profit Adder of Bay Trail for PCs vs Core

$0M

$6

$8

$10

$12

$15

Bay Trail-based PCs

15M

$0.01

$0.02

$0.02

$0.03

$0.03

20M

$0.02

$0.02

$0.03

$0.03

$0.04

25M

$0.02

$0.03

$0.04

$0.04

$0.05

30M

$0.03

$0.03

$0.04

$0.05

$0.07

40M

$0.03

$0.05

$0.06

$0.07

$0.09

50M

$0.04

$0.06

$0.07

$0.09

$0.11

Source: L-sq Advisors

Of the entire tablet market in 2014 (276M estimate, Gartner), if Android comprises 60% of the total and Intel gains 15% of the Android market with Bay Trail (the version for tablets is called Bay Trail-T) at a $20 ASP, $12 cost (40% gross margin), it would gain $199M additional gross profit. Assuming 80% fall-through to operating profit, this would add another $0.02 to Intel EPS. If Intel captured 30% of the estimated Android tablet market in 2014, then Bay Trail would add $0.05 to Intel EPS. A sensitivity analysis covers potential outcomes that range from less than a penny to a dime EPS adder:

Table 2: Sensitivity of Intel EPS Adder: Bay Trail-T Gross Profit, Number of Bay Trail-based Tablets

Gross Profit of Bay Trail in Tablets

$0M

$4

$6

$8

$11

$14

Intel Android Tablets

6M

$0.003

$0.004

$0.01

$0.01

$0.01

12M

$0.01

$0.01

$0.01

$0.02

$0.02

25M

$0.01

$0.02

$0.02

$0.03

$0.04

37M

$0.02

$0.03

$0.03

$0.05

$0.06

50M

$0.02

$0.03

$0.05

$0.06

$0.08

62M

$0.03

$0.04

$0.06

$0.08

$0.10

Source: L-sq Advisors

Thus, based on the PC and tablet opportunities combined, Bay Trail could add a dime or more to 2014 EPS (with stronger momentum more likely in 2H14) that may not be currently factored in consensus estimates.

Chromebooks – An Underappreciated Upside Opportunity?

One other surprise from IDF was the focus of Haswell into the Google Chromebook market, especially as Intel typically takes several quarters before it pushes its latest generation technology into its low-end Core processors (Celeron family) – its main product currently sold into that segment. While Samsung, which uses its own ARM-based Exynos processor, has likely garnered the largest share in the Chromebook market to date (it is listed #1 in Amazon’s best-selling notebooks), the positioning of Chromebooks appears to be increasingly towards replacing Windows-based notebooks, which should benefit from a more capable processor that can support at least 4 gigabytes of memory.

As we would expect Intel to support Bay Trail for Chromebooks in 2014 (time-to-market issues likely hindered support sooner), which may help strengthen its position, Chromebooks have the potential to materially offset processor sales declines in the Windows PC market, which are likely to continue in 2014. Additionally, even as Intel is currently targeting the low-end of its Core processors into this product line, it may be garnering a modest price premium for Haswell vs its prior generation Ivy Bridge as evidenced by the Acer C7, where the new model 720 is being sold at a $50 adder to the similarly spec’ed 710 (the other main difference being 4 gigabytes of memory on the 720 vs 2 gigabytes on the 710).

Net, while Intel’s larger challenges, especially in Windows client PCs, are likely to continue to constrain its potential for earnings growth, it has new opportunities in 2014 that have the potential to drive 5% or more EPS upside to consensus estimates, especially in 2H14. If Intel can execute this upside, it would provide a much needed key result that the new management team not only “gets it” but also is back on the long road towards sustained earnings growth.

DISCLOSURES

I do not own a stock position in any company whose stock is mentioned in this article. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. L-sq Advisors is a consulting firm that may have in the past, present or future solicited and/or generated consulting services from any company mentioned in this article.

BIOGRAPHY

Steven Eliscu is Principal at L-sq Advisors.  He brings a unique combination of Equity Research experience – 9 years at UBS, a leading global platform, as a Semiconductor Analyst – along with more than 10 years of senior Marketing and Business Development roles in the technology industry, including 11 years of rising through the ranks at Integrated Device Technology. With this experience, he intimately understands the basis for valuation from the eyes of the financial markets through the lens of his framework for technology value creation. He has a firm grasp of key technology trends (with 3 patents to his name) and the competitive forces driving the tech industry, which have provided the proper context for his understanding of individual companies and ultimately how each should be valued. He developed the basis for his framework based on his experience as an Analyst, and subsequently refined it and brought it to market as the founding Principal of L-sq Advisors.

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