“A strategic inflection point is a time in the life of a business when its fundamentals are about to change. That change can mean an opportunity to rise to new heights. But it may just as likely signal the beginning of the end. Strategic inflection points are full scale changes in the way business is conducted, so that simply adopting new technology or fighting the competition as you used to may be insufficient. They build up force so insidiously that you may have a hard time even putting a finger on what has changed, yet you know that something has.”
Warren Buffett, investing mogul and hedge fund manager for Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B), surprised many investors by shunning his long-term investing strategy after selling his 11.5 million shares of Intel after less than a year. Buffett purchased the shares between Aug. 8, 2011, and Oct. 20, for an average price of $21.75. The Berkshire Hathaway CEO recognized a $60 million gain, or roughly 25%, on the world’s largest semiconductor company. Buffett liquidated his position in Intel just before the company cut its third quarter sales estimate on Sept. 7 by roughly $1 billion. Influenced by value investing pioneer Benjamin Graham, Buffett employs a modified version of Graham’s approach to value investing. Unlike Graham, Buffett believes that companies don’t have to be bought at a bargain to receive an exceptional return. Assuming a company is fairly priced, generates consistent profits, and has a durable competitive advantage stemming from a unique or low cost product/service, there is an opportunity for exceptional returns.
Intel has a P/E of 9.9 that has shrunk nearly every year since 2009, and is at a 10-year low. This stock may look cheap relative to historical and industry averages, but there are various catalysts built in to that P/E. Intel recognized that demand was weakening in the PC market, and we believe that the combination of phones, tablets, increased competition, and poor economic conditions are goading its valuation downwards. When assessing a company’s durable competitive advantage, Buffett looks for consistency in profits and views rises in research and development as a signal that the company needs to change their product. On an annual basis since 2002, Intel’s highest R&D expense as a percent of revenue was 16.6% in 2006. In the first two quarters of 2012, Intel has invested heavily in R&D, spending roughly 18% of their revenues. Increased R&D spending has caused operating margins and earnings to compress, a sign that may have made Buffett pull the trigger on liquidating his position.
Looking at competitors Intel is facing in the various facets of the microprocessor industry, Advanced Micro Devices, Inc. (NYSE:AMD) is Intel’s largest competitor in the PC market, but it’s still miniscule relative to Intel. The bigger threat to Intel is ARM Holdings, whose processor designs are found in most smartphones and tablets. While Advanced Micro Devices and ARM Holdings are Intel’s largest competitors in each of their respective niche markets, NVIDIA Corporation (NASDAQ:NVDA) competes with Intel in both areas and remains a serious threat. The table below shows a competitive analysis for the microprocessor industry.
Based on the P/E and EV/EBITDA data presented, Intel is clearly the cheapest company followed by NVIDIA, which isn’t priced too much higher. Both Advanced Micro Devices and ARM Holdings have an EV/EBITDA over 30 and are two of the higher priced companies in the microprocessor industry. Intel and ARM Holdings rank ahead of NVIDIA and Advanced Micro Devices in terms of margins. Year-to-date returns revealed that the industry has had a rough year. Both Intel and Advanced Micro Devices have generated negative returns YTD, while ARM Holdings and NVIDIA have incurred slight gains.
Grove’s opening quote on strategic inflection points paints a picture for what Intel is experiencing today. The company is seeing changes in consumer demand and they are not positioned to gain from these shifts. The industry’s transition from PCs to tablets and smartphones has not only affected PC companies, but has also changed the competitive environment in the microprocessor industry. Intel is investing in R&D in attempt to make up lost ground in their positioning to serve the increased microprocessor demand in tablets and smartphones.
It’s important that even without Andy Grove, Intel remains paranoid that increased demand for phone and tablet processors may continue to cut into the demand for PC processors. In an attempt to take advantage of growth opportunities and extinguish threats, Intel has developed the Atom chip for the phone and tablet markets. In the next few years, we expect demand for phone and tablet processors to continue to increase, but the PC market will not disappear. Intel has an impressive record in knocking out their opponents and there’s little doubt that the company won’t continue to dominate the PC market. We believe that their level of success and record of innovation in the PC industry will translate into the phone and tablet industries within the next few years. If Intel’s increased R&D spending leads the company to becoming a market leader in the production of semiconductors for smartphones and tablets, its improvement in margins and earnings will more than compensate for lost demand in the PC market.
