Intel Faces Critical Test

Summary:

• Intel Corporation is racing to catch up in the artificial intelligence market and is facing pressure to return to its winning ways.
• Performance metrics released later this month will be a critical test for Intel momentum.
• We offer our targets and see management focused on margin expansion.
• Cash burn is a wild card, putting Intel momentum at risk.

Intel Corporation (NASDAQ:INTC) is fighting off obliteration. It has been a very difficult time in the history of the company, and this year it reported its largest loss in history for a quarter. This pressure is because it is behind the curve with artificial intelligence (“AI”), but Intel is quickly working to catch up.

We traded this one, as we saw shares a buy when they were in the $20’s, to now and took profits around $34-$35. The stock has clawed a bit above this level, but can the momentum continue? Well, that momentum is going to face a critical test, as earnings are set to be reported later this month. Short term, we could see a sizable move in either direction. Long term, investors are looking for the company to return to its winning ways.

We believe that the chip cycle has troughed, but during this downturn, Intel really took it on the chin. The biggest pressure added to the stock was when income investors jumped ship after the dividend was slashed dramatically in an effort by the company to preserve cash. Right now, there is no earnings growth, and the value is poor due to losses.

However, during the market correction the last two months, INTC stock largely held up. We love buying beaten-down stocks that stand to rebound, and made a successful trade. Investors should be looking for improvement each and every quarter and ongoing process in operations and new tech development, particularly in AI. The pie is huge, and Intel will have its slice. Near-term, the stock is speculative.

We still have other preferred chip stocks which we have discussed at our investing group, but Intel does still have a good long-term future. But you may get a chance to buy this stock cheaper. One possible play is to own a partial position into earnings, and add on a decline. If the stock pops, then great, you made money. If it falls, you can improve your cost basis. For the long-term investor, simple monthly or biweekly dollar cost averaging is an approach, as long as you are holding a few other diversified holdings in the same fashion. In this column, we provide our outlook for Q3 earnings, set to be reported October 26th, as well as other key developments.

Before delving into what we are looking for with Q3 earnings, we do note sentiment has improved in the stock, and investors are placing their bets on a sizable recovery. One key development that we find interesting is that last week, the company informed investors that it will be spinning off its Programmable Solutions Group business as a standalone company. One of the advantages of holding a house position after a trade (that is, selling your initial investment in the trade, plus a little profit, and letting the rest run) is that you can leave the profit invested long term and collect all future gains, dividends, and spinoffs. Here we have the latter. The spinoff is going to take some time, possibly 8-10 quarters, but will raise significant cash for Intel and allow it to sharpen its focus on its core CPU business, and focus on AI initiatives.

While delving into the full AI initiatives is beyond the scope of this column, the AI chip market expected to grow by 30% annually through the next decade. Intel is fighting for its piece of the pie. To be clear, it will have a piece. The size of it depends on execution in coming years.

One project of note is the Gaudi machine learnings processor. This project has unlocked around $1 billion for its AI initiatives over the next year or so. While this is not a major figure for a company with revenues of $50-$70 billion a year, we should expect further momentum and developments in this space. We assume that Intel’s next generation server processors will be used more and more for AI related work processes by customers. The company will also move to add AI engines to other server processors as well. We await more news on developments for AI in accelerated computing chips and graphics as well.

But the AI story is longer term. For now, legacy operations are still a main focus, particularly for performance. There is light at the end of the tunnel for PCs and chip/processing demand there. There was a significant slowdown the last few quarters, but we believe it is troughing and that is great news for the company. In the meantime, the company has worked to strike a balance between advancing its strategic priorities as well as research and development, with costs savings. The company is looking to preserve capital and expand margins after several painful quarters. Overall, there are $3 billion of savings on the table for Intel this year. This will be something we focus on for the earnings report.

So, with that, let’s turn to our broader expectations for Q3. Back in Q2, we saw results that exceeded the high end of management’s guidance. We think in Q3 you see the company continuing to control what it can control, advancing strategic priorities, while slashing costs through its cost savings plans. We will look for updates on investments into its internal foundry model and IDM 2.0.

In our opinion, analysts have set targets that are beatable for the company. Back in Q2, the company beat estimates on both the top and bottom lines and handily did so. Make no mistake, comps with Q3 2022 will look painful in our estimation. In Q2, Intel’s revenue was down 15% from Q2 2022 while adjusted gross margins narrowed again hitting 39.8%. Net income was down 52% from last year’s earnings. The company saw adjusted earnings of $0.13 per share, versus expected losses.

For Q3, we think we see further performance stabilization. The biggest thing we are looking for is progress with margins. While we expect margins to be down from a year ago, we think margins will improve from Q2, but several hundred basis points. On the top line, we are looking for revenue of $13.3-$14.0 billion, on 43.2-44.0% adjusted margins. Assuming the midpoint of the top line is hit, this would be a $1.6 billion decline from Q3 2022’s $15.3 billion in revenue, or a 10.5% decline.

While a decline is expected in performance from last year’s comps, our view of 43.6% at the midpoint for margins stems from the belief that we see the cost savings management has indicated it would work for. We also err on the side that management is somewhat under-promising to overdeliver, even if the comps are still down. Recall, last year adjusted margins were 45.9%. Back in Q3 2021, they were up to 58.3%. But we believe the margin improvement can drive the stock higher, if they deliver. In terms of earnings, management has guided for $0.20 adjusted. With the midpoints of our sales and margins ranges, assuming operating expenses that are commensurate with operating expense as a percent of revenue with Q2, or better, we think adjusted EPS is more likely to hit $0.24-$0.26 which would likely send the stock higher as well.

The other key metric we are looking for is what happens with cash. The company has been burning cash badly. The company did burn another $2.8 billion in cash in Q2. This is another key indicator to monitor. We are looking for the cash burn rate to slow to $1.5-$2.0 billion in the quarter. The company will continue to pay its dividend, and continue investing in its future initiatives.

For now, Intel’s business is still suffering compared to past performance, but we believe the bottom of performance is in, and the momentum of the stock can continue if the company can beat its own estimates and the consensus. While Q2 saw a guide that was a bit above consensus, it may be conservative. If management reports successes on its operational metrics above expectations, we think shares shoot higher. However, an in line report will likely be viewed negatively following the strong rally in shares.

After the biggest losses in history earlier this year, Intel has clawed back to being earnings positive. The PC situation is improving while investing in AI opportunities. The PSG spinoff plan appears to have been well received. Cash, however, is still being burned at a high rate, but we are looking for the burn rate to slow.

We want to hear from you

So, what else can drive Intel shares higher? With a turn higher from the trough, is the Intel dividend safe, or do you think they might raise it next year? Are you also concerned with the cash flows and cash burn? Have more to add regarding AI? Do you expect a beat and raise for Q3? Let the community know below.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of INTC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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