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Intel's Checkup by Motley Fool

Intel's Checkup

Over the next few months, the Rule Maker Portfolio will examine each of its stocks. Intel, our largest holding, goes first. Declining revenue, gross margins, and cash flow are disheartening, but the balance sheet is still in relatively good condition. It's raining hard in the chip industry and Intel has gotten wet, but it remains the dominant player in a growth business.

By Todd N. Lebor (TMF TeeTime)
July 10, 2001

Spring has come and gone, but it's never a bad time for cleaning. So, over the next few months, the Rule Maker Portfolio will be reviewing its current holdings one at a time. Today, we start with our biggest holding, Intel (Nasdaq: INTC).

Currently Intel comprises a little more than 15% of the Rule Maker Portfolio, and judging from the numbers below, I couldn't be happier.

Last Qtr Last 12 Mos
Sales Growth (16.5%) 7.0%
Gross Margins 51.7% 59.7%
Net Margins 7.3% 24.7%
Cash-to-Debt Ratio 8.5 11.7
Flow Ratio 1.26 0.98
Cash King Margin (22.2%) 6.0%

I know. You're thinking I picked the wrong week to stop sniffing glue. But even though the trend line for every financial measure is in the wrong direction and some fail to live up to our stringent criteria, Intel remains profitable and cash-rich. As I wrote last month, Intel is currently scraping its knuckles on the bottom of the semiconductor cycle and still remains a profitable and healthy company.

Sales growth is dismal, but we've seen this before. In fact, this is the pattern with Intel. In Q2 1998, revenue growth was negative, gross margins dropped to 48.9%, the Cash King Margin was negative, and net margins were way off their highs. That happened to be the bottom of the last semiconductor cycle and here we are again. Surprise, surprise, surprise! Intel is in a cyclical business and the investors with linear extrapolitis can only see red. Those who understand the nature of the industry and Intel's place in it can rest easy. We see the trees through the forest.

For the 12-month period following Intel's slide that ended in Q2 1998, it posted revenue growth of 14.7% and free cash flow growth of 145.9%. Gross margins improved 240 basis points and the same short-term investors that bid the share price down jumped back on the Intel bandwagon and drove the price up.

A few numbers that have concerned me for some time are the days sales outstanding (DSO) and days inventory outstanding (DIO). These numbers have been trending up and we want them as low as possible. A low DSO means Intel is collecting its receivables quickly and a low DIO means there is less risk of inventory write-offs. (See this article for a more indepth explanation.)

Q101 Q400 Q300 Q200 Q100 Q499 Q399
DSO = days sales outstanding
DSO 51.0 45.0 45.9 43.4 41.5 39.4 41.5
DIO = days inventory outstanding
DIO 68.3 58.2 50.6 43.1 45.4 44.0 50.4
DPO = days payable outstanding
DPO 99.0 56.5 61.9 51.1 47.1 41.6 43.4
CCC = cash conversion cycle
CCC 20.2 46.7 34.7 35.4 39.8 41.8 48.5

However discouraging the DSO and DIO uptrend is, Intel is managing its cash conversion cycle very well. Basically, it is paying its bills at a slower rate than it is collecting them. As DSOs and DIOs have increased, so have DPOs, so the cash conversion cycle has actually shortened. That's a good thing.

The CCC measures the number of days it takes a company to purchase raw material, convert it into a finished good, sell the finished good, and collect payment on that product. Although Intel is being more generous with its collections, it is taking even more leeway with its suppliers (no doubt as a result of its prowess in the industry) and maintaining a relatively steady cash conversion cycle.

How did we react in early 1998 when Intel was bottoming? That's when we starting buying Intel and for a while there it looked like we were master investors. (For a while there, it looked like everybody was a master investor!) Yet, as Rich pointed out in a recent column, Intel has changed quite a bit since then, so we need to revisit why we invested in the first place.

Intel was the dominant player in the chip market. Check. Intel's products were going to play a significant role in the world over the next five years. Check. Intel was highly profitable. Check. All these characteristics still exist and I'd argue that its dominance is only enhanced by the hazy forecast. Competitors like Motorola (NYSE: MOT), AMD (NYSE: AMD), and Texas Instruments (NYSE: TXN) also have to figure out how to navigate the unexplored seas ahead. Intel's balance sheet gives it a leg up on the competition in times like these.

The balance sheet shows $10 billion in cash and another $2.3 billion in long-term investments. Sure, that's down from $11 billion in cash and $9.8 billion in long-term investments a year ago, but much of that money was spent on capital expenditures. Plus, the move to 0.13-micron technology and 300-millimeter wafer technology is expected to save billions. Intel is gearing up for its future as a manufacturer of all kinds -- networking, communications, and PC -- of chips. Management has proved that it can be the most efficient producer of microprocessors on the planet. Now it must translate that to other types of chips and chipsets.

Debt is a paltry $1.2 billion. However small, this amount has always bothered me. Why would a company with so much cash take on any debt? Well, digging into the 10-K, we see that the nearly $400 million represents non-interest bearing "drafts payable" and the majority of the rest ($600 million) was incurred in connection with the construction of a manufacturing plant in Ireland. Interest is payable in Irish punt and hedged to limit interest-rate risk, so that's reassuring. I can only assume that the political goodwill Intel is earning far outweighs the economic cost.

Over the last decade or so, the Irish government has been pushing its lush green countryside as a tech manufacturing haven. Motorola, Intel, Compaq (NYSE: CPQ) and Dell (Nasdaq: DELL) are some of the largest employers in Ireland. The Emerald Isle has even been jokingly referred to as the 51st U.S. state. So, when the Irish government offers you low-interest financing, you take it and get on with business. The amount is nominal to Intel and based on the $738 million in average long-term interest-bearing debt during calendar 2000 and an interest expense of $35 million for the year, Intel's average interest expense was 4.7%. That's less than what it's earning on its invested cash. This is an example of positive leverage.

If we expected our companies to continually improve margins and never allowed for market corrections, we wouldn't need such tough criteria. We'd need a crystal ball. The reason I'm so pleased with Intel is precisely because it's flexing its financial muscle and it appears the years of disciplined conditioning are paying off.

I'll touch on Intel's valuation next week. Remember, it's important to account for the cyclical nature of a company like Intel when estimating its future cash flow.

Fool on.

Todd Lebor is a co-manager for the Rule Maker portfolio and lives in Alexandria, VA. At the time of publication, he owned shares of Intel. Todd's other holdings can be found online along with the Fool's complete disclosure policy.

http://www.fool.com/portfolios/rulemaker/2001/rulemaker01071...




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