Tiptoeing to a Turnaround in Chips
AUGUST 8, 2003
Business Week
By Thomas W. Smith, CFA
Intel's stronger outlook and a trade group's better forecast show the sector is clearly -- but only slowly -- gathering speed
A highlight of the July earnings season for the semiconductor industry was positive news about Intel's (INTC ) gross margins. The world's largest chipmaker delivered a second-quarter gross margin of 50.9%, which was above our estimate for 50% and the midpoint of its guided range of 50%. This followed Intel's first-quarter gross margin of 52%, which was at the high end of its guidance.
Altogether, we at S&P think Intel did well in hitting its gross margin targets during the first half of 2003, which was a seasonally slow period pockmarked by a price increase in flash memory that cost market share, the Iraq conflict, the SARS epidemic, and mediocre PC sales. Of course, Intel made some of its own luck by introducing in March its Centrino technology that enables wireless connectivity for laptops, which helped steer PC customers toward notebooks with these high-margin chips.
The news about gross margins for the rest of 2003 was the bigger upside surprise, in our view. Guidance for gross margins for both the third quarter and for all 2003 was 54% -- above the 50% and 51% we had modeled, respectively. To make 54% for the year, Intel's fourth-quarter gross margin needs to be 57% or better, and we have modeled 58%.
NO PC SURGE YET. While the jump may appear big, unit-volume gains from cycle-low levels can often dramatically improve wafer fab efficiency. Gross margins for chipmakers can also be affected by product mix, average selling prices, inventory valuations, and the timing of startup costs for new product lines.
Interestingly, Intel reports no surge in PC sales immediately ahead, although management has faith that sooner or later customers will need to replace aging computers bought in 1999 for Y2K compliance. Confirming the no-surge-yet thinking, the company left its plans for capital spending unchanged at $3.5 billion to $3.9 billion. Of course, whenever PC sales do finally accelerate, Intel should benefit, as will the rest of the chip industry.
Intel's ability to improve gross margins at today's modest revenue levels boosts our confidence in its ability to earn substantial profits as the industry cycles up. We project an expansion that should endure into 2006, based on rising U.S. gross domestic product, the need to replace aging tech gear, and the desire to upgrade equipment to gain the advantages of wireless connectivity.
HAZY FUTURE. After Intel's second-quarter earnings report, we raised our earnings-per-share estimates to 67 cents for 2003 and to 85 cents for 2004, and upgraded the shares to 5 STARS (buy). With Intel trading near $24 on Aug. 7, the price-earnings ratio on our 2004 estimate is 28, which is at premium to the S&P 500-stock index but in line with peer companies.
Looking into the hazy future, we estimate EPS for 2005 of $1.05. Our 12-month stock-price target of $32 is based partly on applying a p-e of 30 (near the current forward p-e of 28) to our $1.05 estimate for 2005, and partly on discounted cash-flow analysis, which indicates an intrinsic value near $32. Our DCF model's assumptions include annualized growth of cash flows over 15 years at 13.5%, then annual growth to perpetuity at 4%, and a weighted-average cost of capital of 11%.
The potential price appreciation from $24 to our target is about 33%. Risks to achieving that level include the pace of the economy, fluctuations in chip pricing, competition, execution of product launches, wafer fab efficiencies, and valuation levels for semiconductor stocks.
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Supporting our notion that the semiconductor industry expansion is slowly gathering speed is the Aug. 2 release from the Semiconductor Industry Assn. announcing that second-quarter worldwide chip sales rose 10.4% year-to-year and 3.2% from the first quarter. Sales for the first half of 2003 were up 11.8% year-to-year, which is in line with our forecast for 12% industry growth for all 2003 and above the SIA's 10.1% growth forecast.
Intriguingly, the SIA raised its forecast for third-quarter sales growth to a 5% to 8% increase over the second quarter. The midpoint of that range, 6.5%, is higher than the SIA's prior forecast of 5.8%. Despite the increase for the third quarter, the association didn't raise its forecast for the whole year, reasoning that the outlook for the fourth quarter was too hazy to merit a change from its 3.7% forecast. |
