Intel: Bumps In The Road To Foundry Success Led To Excessive Negative Pressure On Shares

Investment thesis

Disappointing profitability results that were below both Intel (NASDAQ:INTC, NEOE:INTC:CA) management’s and analysts’ expectations, the announcement of a workforce reduction of more than 15% by the end of 2025, the suspension of dividend payments at the beginning of the fourth quarter of 2024, and lower-than-market guidance combined to cause Intel’s stock price to drop more than 18% in after-hours trading following the release of the company’s earnings report for the second quarter of 2024.

Subsequently, a series of negative news (possible exclusion from the Dow Jones index), rumors about which of the company’s divisions would be sold and, in general, a broad market sell-off, which affected big tech companies more negatively than other sectors, led to additional volatility in the company’s shares and, in our opinion, created the whole negative background to which the company is now exposed.

In the report below, we propose to consider how the company feels by segment, since in our opinion the investment case remains (or previous article is available via this link): Intel is investing heavily in its own foundry, producing products for AI PCs, and also developing the DCAI segment, within which the release of an AI accelerator will start in Q3 2024 Gaudi 3.

Revenue meets expectations, but guidance goes down

In 2Q 2024, revenue in the Intel Products (CCG, DCAI, NEX) segment totaled $12.2 bln (+0% y/y), compared with our expectations of $12.4 bln. It made up 92% of Intel’s total revenue.

The Client Computing Group (CCG) segment earned $7.4 bln (+9% y/y). Helping the growth was a gradual recovery in PC shipments as well as an increase in average revenue per customer, although that was partially offset by license restrictions that were imposed on exports to China during the quarter.

In general, the strategy of the sub-segment remains unchanged, except that the management is trying to stimulate new product releases. In 2Q 2024, it was decided to accelerate the release of Core Ultra AI processors in order to strengthen the position in this market and to maximize the future potential benefits of the trend toward replacing conventional PCs with AI PCs.

According to the latest forecasts from the research agency IDC, global PC shipments will remain about the same in 2024 as a year earlier, as previously expected, growth will be hobbled by slowing demand from China. Consequently, we also expect shipments to decline in 2025, as demand in the Chinese market is expected to remain depressed until 2H 2025.

As such, we are lowering the forecast for revenue in the CCG segment from $32.4 bln (+11% y/y) to $30.6 bln (+4% y/y) for 2024, and from $39.3 bln (+21% y/y) to $35.4 bln (+16% y/y) for 2025.

The Data Center and AI (DCAI) segment brought in $3.1 bln for the company in 2Q 2024, and when put together with the earnings of Altera, which used to be part of this segment, the number stands at $3.4 bln (-15% y/y). The company noted a slightly weaker demand for traditional server processors and expects a moderate improvement in 2H 2024 (smaller than previously expected).

The nearest revenue driver for the segment could be the expected release of the Gaudi 3 processor in 3Q 2024, which is a cost-effective alternative to advanced GPUs from NVIDIA and AMD that are expensive and scarce. According to the management, the price of the Gaudi 3 will be 30% lower compared with competing products, which should also have a positive impact on sales.

Given the lower demand for the segment’s products in 2Q 2024 and Intel’s moderated expectations for the pace of its recovery, we are cutting the forecast for the DCAI segment’s revenue (including the separated Altera unit) from $14.8 bln (+17% y/y) to $14 bln (-10% y/y) for 2024, and from $15.8 bln (+6% y/y) to $14.9 bln (+6% y/y) for 2025.

The outlook for the Network and Edge (NEX) segment remained largely unchanged from the last report, but the company expects a slower revenue recovery in the coming quarters, similar to other Intel Products segments, and as a result, we have lowered our forecast accordingly.

Therefore, we are lowering the forecast for Intel’s revenue from $56 bln (+3% y/y) to $52.8 bln (-3% y/y) for 2024, and from $65.3 bln (+17% y/y) to $59.8 bln (+42% y/y) for 2025.

In expectation of lower results, the company guided for $12.5-13.5 bln in 3Q 2024.

Intel Foundry

Intel’s foundry capacity is at an early stage of development (relative to global industry leaders) and so far, has an uncompetitive cost structure (as pre-EUV nodes still account for more than 85% of production volumes) and a shortage of manufacturing space.

To accelerate the development of the foundry business, Intel appointed new experienced and market-savvy executives to Intel Foundry, such as Kevin O’Buckley (as the new general manager of Foundry Services) and Naga Chandrasekaran (as the new general manager in charge of foundry manufacturing and supply chain), who previously worked at Micron Technology.

We expect the Intel Products segment to continue to be a revenue generator in the coming years, which the company will continue to use to make up for Intel Foundry’s operating losses.

As part of its plan to reduce costs and improve liquidity, the company raised capital requirements, which caused the guidance for capital expenditures to go down to $25-$27 bln for 2024 and $20-$23 bln for 2025. The 2024 reduction represented more than 20% of the guidance that was announced at the start of the year, which reflects, among other things, the management’s expectations of falling demand in 2H 2024.

Given grants and partner contributions for the development of the foundry business, Intel issued a guidance for net capital expenditures of $11-13 bln for 2024 and $12-14 bln for 2025. In a base-case scenario, we assume that the size of grants and partner support will fall sharply by 2026, so in the absence of additional information, we equal them to zero in our calculations for the time being.

Operating margin disappoints investors

The company’s 2Q 2024 operating income missed the management’s expectations (and market expectations, too), coming in at ($1.96) bln, with a negative operating margin of (15.3%).

Focusing on long-term rather than short-term benefits, in 2Q 2024, the company’s management decided to ramp up production of Core Ultra AI processors to better position the business to ride the AI trend in the industry, and accelerated transition of Intel 4 and 3 wafers from the development fab in Oregon to the high volume facility in Ireland, which will reduce gross costs in the future due to scale effect. So, while both initiatives caused a short-term decline in the company’s profitability, they are positive in the long run.

In order to improve financial performance, the management developed a plan to cut costs, including by reducing headcount by more than 15% by the end of 2025 (with most of the plan to be executed by the end of 2024). As a result, the management expects the company’s operating expenses to total $20 bln in 2024, $17.5 bln in 2025, and so on, and intends to maintain this trend in absolute terms.

However, given the aforementioned initiatives, we do not expect such a strong reduction in operating costs in the next few years, as it would imply too drastic a reduction in R&D and SG&A. The year 2024 is a case in point: OpEx was already as much as $12.8 bln in 1H 2024, which would leave $7.2 bln for 2H 2024, but the restructuring is clearly not yet complete and layoffs will require the payment of compensations, limiting the scope for cost reduction.

As a result, we have lowered the forecast for operating costs to $24.9 bln for 2024, and to $20.3 bln for 2025; and the forecast for operating margin from (1%) to (10%) for 2024 and from 8% to 3% for 2025.

Financial results

We are lowering the forecast for adjusted EBITDA from $13.8 bln (+7% y/y) to $8.1 bln (-37% y/y) for 2024, and from $20.3 bln (+47% y/y) to $16.5 bln (+103% y/y) for 2025 due to:

• the reduced revenue forecast for 2024 and 2025;
• the reduced operating margin forecast for 2024 and 2025.

We are lowering the forecast for the company’s free cash flow from ($13.6) bln to ($16) bln for 2024, and are raising it from ($7.8) bln to ($4) bln for 2025 due to the reduced forecast for operating income, which was partially offset in 2024 and more than offset in 2025 by the lower forecast for gross capital expenditures.

For the entire forecast period (3Q 2024 – 4Q 2027) the free cash flow forecast has been raised from ($16.4) bln to ($5.6) bln, which made a positive impact on the outlook for the company’s net debt.

In the conference call on the company’s 2Q 2024 earnings, the management announced dividend payouts will be suspended starting from 4Q 2024. In the face of rapidly declining profitability and lack of liquidity, the company decided to focus spending on the most necessary investments (raised capital requirements), restructuring the business to build a solid and profitable business model and decreasing its leverage.

As soon as the company is able to increase and stabilize its cash flows, it will return to paying dividends.

According to our outlook, the company will return to positive net income of $2 bln in 2025, but we don’t believe this will guarantee a resumption of dividend payments, as compared with the size of Intel’s business, $2 bln in net income is not a high number, and it will not convince the management that the situation of having to suspend payments will not happen again.

Valuation

We are lowering the target price of the shares from $49 to $39 due to:

• the reduced EBITDA forecasts for the period from 2024-2027 (negative effect);
• the reduction of the projected net debt from $42 bln to $20 bln based on consistent reduction of actual net debt by $7 bln, an increased forecast for FCF, and including in the calculation Intel’s guidance for net capital expenditures (positive effect);
• the shift of the FTM valuation period (positive effect).

Based on the new assumptions, we are assigning a BUY rating to the stock.

The price of $39 was achieved by computing a target price based on 2027 financial results and discounting it to the FTM estimate at the rate of 13% per annum.

The discount rate of 13% is the average growth of the S&P 500 Index over the past 20 years. In other words, when we value a company based on its long-term results, it is important to us that the company’s growth exceeds the average growth of the index.

Calculating the risk of Intel being removed from the Dow

The company’s stock was added to the Dow Jones Industrial Average (DJIA) index in 1999, one of the first technology stocks to be included. Now, however, a significant drop in the company’s stock price could lead to Intel’s removal from the index.

Since the beginning of the year, INTC stock has fallen more than 60% to levels last seen 11 years ago, the worst performance of any company in the DJIA.

Since the release of the company’s Q2 earnings report in August, investors have been reacting quite strongly to rumors/news about the company, putting additional pressure on the stock.

In addition, a broad sell-off in the market in recent days has had a more negative impact on big tech companies. News about the removal of Intel Corp. from the Dow Jones index served as an additional reason for the decline in INTC quotes.

According to our calculations, if the company’s shares are indeed excluded, the outflow of ETF funds from the index will amount to less than 0.15% of Intel’s capitalization, which is insignificant. The potential impact is so small because INTC is such a small component of the DJIA index – only about 0.3%.

Thus, the negativity associated with the news of the potential removal of the stock from the index is more than reflected in INTC shares. This was due to a broad market decline and pressure on Intel Corp. On the investor side, due to the risks associated with the company’s foundry business and all the resulting cost-cutting measures (job cuts, suspension of dividend payments, etc.), the actual negative effect of the company’s exclusion from the DJIA will amount to slightly more than $100 million (out of Intel’s current capitalization of $80.60 billion).

Conclusion

Thus, we see that the company intends to overcome operational difficulties, is striving to strengthen its position in all segments of its market presence (even at the expense of short-term profitability), and is also actively developing its foundry production and not skimping on investments in it.

As a result of the reassessment, the target price for Intel shares was lowered to $39, but the BUY status was maintained. Given the immutability of the investment. We believe that such a strong drawdown, the fact that the quotes are already excessively negative based on known facts, can serve as a good entry point into a position / place for averaging.