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Technology Stocks : Intel Corporation (INTC)

INTC 46.47

-4.5%

Jan 30 9:30 AM EST

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To: Road Walker who wrote (2017)	7/1/1996 12:05:00 PM
From: Andrew Chow	of 186894

On R&D and free cash flow - All other things being equal, R&D is a good thing. But we need to be very careful what we mean by "all other things being equal". What I mean is that pre-tax profits are equivalent. In other words a company that spends 40% of revenues on cost of goods sold and 10% of rev on R&D (and thus has a 50% profit margin), is better than a firm that spends 50% of revenues on COGS and also has a 50% pre-tax profitability level. Clearly a firm that has to spend 10% of revenues on R&D in addition to 50% COGS is going to have a lower P/R ratio than a firm that spends no money on R&D and has a 50% COGS expense. Why is R&D good? Because the R&D is a fixed cost and hence implies greater economies of scale in its industry. This in turn implies greater barriers to entry, which is the key variable in determining what multiple to apply to earnings. Additionally tax treatment on R&D is usually at least as good as COGS treatment. It is interesting to note that advertising in the sense that it is used to "build a brand" is also a fixed cost, and hence a barrier to entry similar to R&D (but the tax treatment isn't as good), so I tend to agree with your KO vs. INTC comments. As far as free cash flow (FCF) goes, a company with more FCF is GENERALLY worth more than a firm with less FCF but the same reported earnings. The firm with less FCF (Intel for example), is "trading" cash for other assets (in this case plant and equipment mostly). Those other assets' value will tend to decline over time (depreciation) as opposed to cash which grows. The only way the low FCF firm can make up this lost ground is if the assets purchased can generate a high enough return on those assets (ROA). This is tough for Intel since the lifespan for a frontline CPU fab is only 2yrs. So what IS the ROA for the boys and girls in Santa Clara? Year ROA ROA (fixed) 1987 9.9% 27.8% 1988 12.8 40.3 1989 9.8 30.4 1990 12.1 39.2 1991 13.0 37.9 1992 13.2 37.9 1993 20.2 57.4 1994 16.6 42.6 1995 20.4 47.7 The ROA on fixed assets numbers are numbers by any standard. Of course they need to be to justify INTC use of cash to buy plant and equipment instead of repurchasing shares. Astute observers will notice the increase in ROA in the middle of the 90's coincides with the accelerated pace of CPU introductions - that is no random event. Can INTC continue to generate these kind of numbers? If not, then today's current use of cash to buy fixed assets (the FCF deficit if you will) must assuredly impact the stock price. The market's current earnings multiple seem to imply some fear that INTC new assets will not be as productive.

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