1 Put Intel Inside Your Portfolio Group 31: Wes Aull, George Becatoros, Chris Brigham, Yara Lynn

el Daher I. Introduction to Intel Long the dominant player in the market for computer microprocessors (CPUs), Intel currently faces a significant shift in the market for consumer electronics to mobile devices. Founded by Robert Noyce and Gordon Moore in 1968, the company was led for many years by the inimitable Andy Grove. The company is currently run by President/CEO Paul Ottelini, who will be stepping down in May 2013. Intels stock has been publicly traded since 1971, when it was listed for the equivalent of 2.0 cents.1 While Intel is decidedly not unknown by any measure due to its Intel Inside promotional campaign, its stock is a fallen angel. The stock did not suffer from a sudden decline but has languished for the past decade. After hitting a high of $70 during the dot-com boom, the stock has mainly traded in a range from $15 to $30 per share since 2001. The company has transparent financials and is not particularly complex to analyze. The potential investment opportunity has arisen as the company has become unloved by the market due to the boom in smartphones and tablets, markets in which Intel has not laid claim. However, the market appears to be overlooking the companys ability to adapt over time, its history of leadership in technological processes, its leverage to the new world of cloud computing, and the fact that for serious computing, people continue to opt for traditional computers. As a result of the markets dismissal of its prospects, Intels stock appears to be at its cheapest level in decades, with a price/earnings ratio of 10, an EV/EBITDA of 4.5, a price/book ratio of 2, and a PEG ratio below 1. The company continued to perform through the recent recession, unlike peers Micron and AMD, whose currently negative earnings prevent comparison of P/E ratios. Compared to companies with positive earnings, Intel looks inexpensive. For instance, ARM, Qualcomm, and NVIDIA trade at P/Es of 75, 17, and 14, respectively. Given its current valuation and its venerable history replete with competitive advantages, Intel gives every appearance of being a franchise business whose stock is suffering from neglect and mistaken perceptions of obsolescence. We expect the company to be every bit as relevant in 10 or 15 years as it is today and view the stock as a sound purchase at current levels. II. Historical Competitive Advantages and Current Industry Trends a. Personal Computer Processors i. Intel Inside 80% of Laptops and Desktops Intels greatest competitive advantages exist in the market for microprocessors for the personal computer market, which it has dominated for decades. According to IDC, Intel held 80% market share at the end of 2012, lower than the 90% that it has traditionally garnered. Thanks to its original connection with IBM, the power of the Wintel platform over the years, and the adoption of Intel chips in Apple computers in 2005, Intel has managed to continuously protect its entrenched position in the personal computer market. Its large market share has
1

Adjusted for 13 subsequent stock splits

2 allowed Intel to spread its R&D and other fixed costs over more units than its competitors, permitting the company to outspend and stay ahead of or at least even with its rivals. As a result, Intel has been able to innovate consistently and maintain a technological lead over its competitors, a behavior we expect it to continue. The drawback to Intels competitive strength in this market is that PC sales appear to be destined for decline as consumers shift their personal computing to mobile devices such as tablets and smartphones. This is one of the key weaknesses upon which the market appears focused. On the other hand, an advantage for Intel is that the declining market should discourage new entrants and also create challenges for the smaller players who attempt to compete with Intel, which should serve to enhance its competitive advantages in this arena. ii. The Ultrabook Competitive Advantage 2.0? The high-powered but still portable option which recently entered the computing market is the Ultrabook, a smaller-sized, lighter-weight, faster-starting device which blends the benefits of a notebook and a tablet. Intel has made Ultrabooks a key element in its strategic initiatives going forward and is poised to transfer its leadership from the PC market to this new segment. Given Intel chips computing power and the companys relationships with major PC manufacturers in the Ultrabook market, Intels competitive advantage from the PC market should transfer directly to this new arena. Although portability and energy efficiency are important in this market, Intels history of developing powerful chips and its focus on new interfaces should allow it to compete effectively. Likewise, manufacturers trust in Intels reliability and the scale which allowed it to fend off competitors in the PC market should continue in Ultrabooks. In fact, ten of the top Ultrabook manufacturers already use Intel chips in their products. This is a viable and expanding business in which Intel is strongly positioned as a result of existing competitive advantages. b. Data Center (Server) Chips Dancing in the Clouds Like the PC market, Intel has dominated the data center market for years. Although the market to manufacture servers has grown more competitive, Intel still rules the market for server chips. In 1998, Intels three top data center customers (Dell, HP, and IBM) accounted for 75% of its data center revenue. Today, eight server makers account for 75% of its data center revenue. One fact appears certainthe emergence and growth of cloud computing is leading to an arms race for server makers and cloud providers. Fortunately for Intel, it is effectively the arms dealer of choice for every player, controlling 90% of the server market. Given the importance of reliability to server manufacturers and users, Intels technological prowess and reputation are essential. The same types of competitive advantages that allowed them to dominate the PC market should allow them to continue to dominate this market. The main risk to Intels competitive moat in this segment is the rapid growth of cloud computing, as it could provide challengers the scale required to effectively compete against Intel. c. Tablets and Smartphones and BearsOh My Despite Intels tremendous competitive advantages in the PC and server markets, it has been unable to crack the new markets for smartphones and tablets. Given the recent emergence and rapid rise of these segments, no sustainable competitive advantages appear to have been

3 cemented. Many firms are entering the market and its rapid growth may allow several of them to achieve critical mass. The key player in this segment is ARM, which rose to prominence because of its relationship with Apple. ARMs processor architecture currently dominates the smartphone market, however the company does not hold any durable competitive advantages. ARM originally developed its architecture with small devices in mind (i.e. MP3 players). Accordingly, ARMs research and development have been primarily geared towards low power consumption. With the advent of smartphones and tablets, ARM offered an architecture oriented towards significant power efficiency, a need long ignored by Intel. Unlike Intel, ARM does not manufacture its own microprocessors but instead licenses its designs to companies like NVIDIA and Qualcomm. Because of ARMs emphasis on power consumption and its licensee model, it quickly came to dominate the mobile market. As of mid-2012, ARMs architecture could be found in 95% of the mobiles. However, despite being in the right place at the right time, ARM has not created a competitive moat in the market for mobile chips. The importance of chip efficiency has put Intel in a disadvantageous position in this new market. Its chips have historically been more powerful but also used more energy. However, as in its other endeavors, Intel has found the technology to compete. In fact, the Motorola RAZR i (with Intels processor) outlasts the nearly identical RAZR M (with ARMs processor). As smartphone and tablet usage becomes more demanding and require more computing power, Intels stronger processors will be increasingly well suited to compete, especially now that the company has focused its attention on efficiency. Going forward, we expect Intel to innovate and compete but do not expect any company to dominate this segment in the way Intel has the PC and server markets. As a final note, manufacturers may have learned from the experience of the PC market. Rather than face a single powerful supplier, they may prefer to work with multiple chipmakers. On the other hand, it obviously also makes sense for them to find a chip architecture that works for them and to build multiple technologies around that. We do not seek to predict their behavior. We simply note that neither case spells success or disaster for Intel. d. A Future as a Foundry? Following Intels recent deal with Altera, it has been speculated that it may take advantage of excess capacity to produce chips for other companies. We view this as more of a peripheral bonus than a competitive edge for Intel. Foundry partnerships are not based on Intels architecture, which is where the competitive advantages of Intels design experience, best-inclass processes, and scale are concentrated. As a result, we think that while the foundry business could be a potentially useful side activity to take advantage of Intels infrastructure and to defray the companys fixed costs, management attention is better spent outside this area and focused on those areas in which the firm has durable advantages. III. Analysis of Strategic Decisions Intels acquisition strategy revolves around improving its existing core processor offerings. Its most recent investment (a 15% stake in ASML in exchange for ~$4 billion) was consummated to bankroll ASMLs R&D related to 450mm silicon wafers and extremeultraviolet chip-making. Intel wishes to accelerate the development of 450 mm silicon wafers

4 due to the large cost savings it would create for the company. According to analyst estimates, Intel could save $2 billion annually on 450mm processes versus the 300 mm standard. As Intel works towards creation of a winning processor design for mobiles and tablets, it has turned outward in order to acquire the technology necessary to achieve that goal. In 2011, Intel acquired Infineons Wireless Solutions (WLS) business for $1.4 billion. Intel is maintaining WLS as a separate business in order to allow WLS to continue servicing its existing customers in the same manner as before the acquisition. The importance of this acquisition has been mainly to accelerate Intels development of baseband processors for 4G LTE to be offered in Intels processor architecture for future smartphones. In June 2012, Intel paid InterDigital $375 million for 1,700 patents and related rights in the 3G, 4G and Wi-fi technology spaces. At around the same time, it completed the purchase of patents and patent applications relating to Wi-fi and LTE from Aware Inc for $75 million. The rate of return on these investments is not expected to be quickly observable. As such, our team regards these investments as akin to R&D for patents that could create value for future product lines. In 2011, Intel acquired McAfee, the computer security software firm, for $7.68 billion. This is Intels most controversial and outlying acquisition in recent years. Intel argues that creating more effective security requires implementation throughout an ecosystem (software, hardware, et cetera). Thus, synergies could be created through processor/software offerings that are tightly aligned between Intel and McAfee. While this may be possible, the results do not seem obvious and the reasoning seems speculative. Although the McAfee acquisition appears to have added marginal profits to the loss-making software and services operating segment, given its high price, this deal has destroyed shareholder value which we do not expect it to reproduce in the future. IV. Asset Value and Earnings Power Value of Equity To arrive at a replacement value of Intels assets, we adjusted the value of several line items and added non-accounting items to the balance sheet to represent the true cost of recreating Intels asset base. We added back part of the accumulated depreciation for PP&E, adjusted its marketable equity securities to reflect ASMLs current share price, and eliminated accounting goodwill. We valued the employee base at 10% of estimated annual salaries, which would be the cost of hiring a workforce of 105,000 people. To represent the value of the companys R&D, we capitalized it based on 100% of 2012 R&D expense, 80% of the 2011 figure, 60% of the 2010 figure, and so forth. While much of Intels marketing and brand value is done by sales representatives, we did not want to double count the value of those employees, so we estimated additional brand value by capitalizing advertising expense as we did the R&D expense. After all adjustments, we estimate the asset value of Intels equity to be around $90bn (~$18 per share). In calculating Intels earnings power, we began with a normalized EBIT margin of 27%. Based on charges for the past six years, we estimated additional normalized charges for restructuring, impairment, and amortization of intangibles of $350m. We estimated 25% of R&D expense and 10% of MG&A expense were used for growth, adding this back to our sustainable earnings. We also added back depreciation and amortization and subtracted maintenance capex of around one-fourth of net PP&E. Actual capex has typically ranged between one-third and onefourth of PP&E, as per Exhibit 6. The difference between the actual capex and our maintenance capex has been used to fuel the companys growth. After deducting income taxes at a normalized rate, we arrive at owners earnings of $12.7bn. We estimate a cost of capital for the company of just under 10%. Intels debt, leases, and unfunded pension liability roughly offset its cash and

5 equivalents and we arrive at a market value of equity of around $130bn (~$26.70 per share). We consider the $40bn difference between EPV and AV to be justified by the companys substantial competitive advantages. V. Value of Growth, Rate of Return, and Margin of Safety Despite the value-destroying McAfee acquisition, Intels post-tax ROIIC appears to be around 24%. This compares to a cost of capital of 9.8% and a marginal cost of capital based on recently issued debt below 3%. The company has returned $20.8bn in dividends and $23.6bn in net buybacks in the past six years, versus net earnings of $52m. With a current earnings yield of 10%, that equates to a cash return of 8.6%. Given the companys competitive advantages, reinvested earnings have historically added value, although if Intel makes a large push into smartphones and tablets and if that market is as competitive as we expect, these investments will likely earn only their cost of capital. On the other hand, if Intels innovation and customer relationships allow it to change the market structure and gain competitive advantages in the smartphone/tablet markets that would be a driver of value creation going forward. Given current circumstances, we seek not to predict the outcome but to remain conservative. Based on Intels historical ability to add value, we estimate a reinvestment return of 3.6%. The main headwind Intel faces is the structural decline of the PC business. We estimate a 3% rate of decline based on recent industry trends and a 30-year erosion period. Unlike the PC business, the data center market is growing. In our calculations, we assume a conservative 5% growth for this market. Assuming other segments grow at 2% (units growing with GDP, prices falling slightly) and blending Intels sales mix with our growth assumptions results in an organic growth rate of -0.6%. Still, compared to a market return of 7%, this provides a margin of safety of 4.6%. Even factoring in franchise erosion of 2.5% per year (based on the companys current 40+ year existence), there is a net margin of safety of 2.1%. VI. Investment Recommendation Based on our analysis, we recommend the purchase of Intel stock at current levels. Given its tremendous R&D capabilities, its hold on customers in certain markets, and the resulting economies of scale, Intel benefits from the existence of sustainable competitive advantages in several markets. Given its technological process leadership and history of innovation, it also has the potential to create a competitive position in developing markets as new technologies emerge. However, our buy recommendation stands on its own. Positive developments in new markets such as smartphones/tablets could add value but are not essential to our thesis. As can be seen in Exhibit 1 and 2, Intels stock is currently trading near historically low levels relative to asset value and earnings power value. Accordingly, we consider it to offer a sufficient margin of safety at current levels and recommend it as a sound investment.

6 Exhibit 1: Comparison of Intel market value to AV and EPV

Intel Valuation
300,000 250,000 200,000 150,000 100,000 50,000 0 1990 1995 Market Value 2000 Adj Book Value 2005 EPV 2010

Exhibit 2: Comparison of market-to-book and market-to-adjusted book values

Market-to-Book and Market-to-Adjusted Book Ratios

9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 1990 1995 2000 2005 Market-to-Adj Book 2010 Market-to-Book Ratio

Exhibit 3: Intel operating data

Intel Revenues and Operating Expenses

60,000 50,000 40,000 30,000 20,000 10,000 0 1990 1995 2000 2005 2010 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0%

Revenues

R&D (% of Rev)

MG&A (% of Rev)

Exhibit 4: Intel performance by segment

8 Exhibit 5: Intel ROIC and dividend histories

Intel Adjusted Pre-tax ROIC

45% 40% 35% 30% 25% 20% 15% 2007 2008 2009 2010 2011 2012 38.2% 37.6% 36.9% 42.0% 37.5% 32.4% 1.00 0.80 0.60 0.40 0.20 0.00

Dividends Per Share

2004

2006

1990

1992

1994

1996

1998

2000

2002

2008

2010

Exhibit 6: Comparison of PP&E levels vs. capital expenditures

Intel PP&E vs CapEx

35000 30000 25000 20000 15000 10000 5000 0 1990 1995 PP&E, net 2000 CapEx last 4 Yrs 2005 2010 CapEx last 3 Yrs

Exhibit 7: PC industry sales statistics (data and forecasts courtesy of Gartner)

2012

9 Exhibit 8: Asset value of Intels equity

Adjustments to 2012 Balance Sheet Current assets Cash and equivalents Short-term investments Trading assets Accounts receivable, net Inventories Deferred tax assets Other current assets Total current assets Long-term assets Property, plant and equipment, net Marketable equity securities Other long-term investments Goodwill Identified intangible assets, net Other long-term assets Capitalized operating leases Value of employee base Capitalized R&D Additional brand value Total long-term assets Total assets Current liabilities Short-term debt Accounts payable Accrued compensation and benefits Accrued advertising Deferred income Other accrued liabilities Total current liabilities Long-term liabilities Long-term debt Long-term deferred tax liabilities Other long-term liabilities Capitalized operating leases Unfunded pension liability Total long-term liabilities Total liabilities Asset value of equity 2012 Actual 8,478 3,999 5,685 3,833 4,734 2,117 2,512 31,358 27,983 4,424 493 9,710 6,235 4,148 0 0 0 0 52,993 84,351 +/Adjust. Multiple Adjust 2012 Adjusted 8,478 3,999 5,685 3,871 4,734 2,117 2,512 31,396 46,530 4,787 493 0 6,235 4,148 831 445 24,179 5,688 93,336 124,732 Notes No adjustment No adjustment No adjustment Add back allowance for doubtful accounts No adjustment No adjustment No adjustment

38

18,547

-100%

831 445 24,179 5,688

Add back depreciation on land/buildings, assume machinery/equipment halfway through useful life, construction in progress current Estimate of current value, based on ASML's current stock price Mostly corporate bonds and govt bonds Eliminate accounting goodwill No adjustment Unadjusted / 992m in equity method investments / 1,202m in non-marketable cost method investments / also DTAs, loans, other Capitalized operating leases 10% of estimated annual salary, cost of hiring equivalent workforce Capitalization of R&D spend Capitalization of advertising spend

312 3,023 2,972 1,015 1,932 3,644 12,898 13,136 3,412 3,702 0 20,250 33,148 51,203

312 3,023 2,972 1,015 1,932 3,644 12,898 13,136 3,412 3,702 831 1,925 23,006 35,904 88,828

No adjustment No adjustment No adjustment No adjustment No adjustment No adjustment

831

No adjustment No adjustment No adjustment Capitalized operating leases Current plan assets less current pension benefit obligation

10 Exhibit 9: Owners earnings, EPV, and margin of safety

Owner's Earnings and EPV Reported operating income Normalized EBIT margin Normalized EBIT +Normalized other items +Growth operating expenses +Depreciation & amortization -Maintenance capex Adjusted EBIT Adjusted EBIT margin Income tax Owner's earnings Cost of capital Earnings power value Less: Book value of debt Less: Capitalization of operating leases Less: Unfunded pension obligations Plus: Cash, equivalents, and ST invest. Market value of equity 2007 2008 2009 8,216 8,954 5,711 27.0% 10,350 10,148 9,484 (350) (350) (350) 1,979 1,976 2,206 4,798 4,616 5,052 4,466 4,639 4,547 12,311 11,751 11,846 32.1% 31.3% 33.7% 3,357 3,204 3,230 8,955 8,547 8,616 9.8% 91,283 87,129 87,832 100,960 125,392 129,980 2,122 1,287 2,221 2,115 7,331 13,448 831 831 831 831 831 831 522 645 455 668 1,484 1,925 15,363 11,843 13,920 21,885 14,837 18,162 103,171 96,208 98,245 119,230 130,583 131,937 2010 15,588 11,778 (350) 2,275 4,638 4,725 13,617 31.2% 3,713 9,904 2011 17,477 14,580 (350) 2,855 6,064 6,236 16,912 31.3% 4,611 12,301 2012 14,638 14,402 (350) 3,343 7,522 7,386 17,531 32.9% 4,780 12,751 Investment Decision Tangible Book Value Unadjusted Book Value Asset Value of Equity Earnings Power Value of Equity Implied Franchise Value Current Market Capitalization Implied Discount to Fair Value Implied Return Total investment return Net margin of safety 35,258 51,203 88,828 131,937 43,109 104,212 21.0% 26.6% 11.6% 2.1% per share 7.13 10.35 17.96 26.68 8.72 21.07