Intel Corp. (INTC, Financial), once the dominant and most innovative PC chipmaker in the world, has found itself in troubled waters over the last few years. Much of the company’s struggles stem from its failure to keep up with its peers from an innovation perspective.
On Feb. 22, the company announced that its quarterly dividend will be slashed to 12.5 cents a share from 36.5 cents per share, which caused the stock to trade lower. A closer look at the company’s financial position reveals this is a prudent move that should be welcomed by long-term investors. That being said, the company still has a long way to go to get itself in order and provide value to shareholders in the long run.
The dividend cut makes sense
A quick look at Intel’s financial performance in 2022 is all it takes to understand the challenges the company is facing. First, revenue declined by 16% year over year to $63.1 billion. The gross margin also contracted by more than 1,000 basis points to 47.3%. Finally, earnings per share plummeted 65% year over year to $1.84.
In addition to this lackluster performance, the company expects revenue to decline 40% year over year in the first quarter of 2023, resulting in a net loss.
Last year, Intel distributed nearly $6 billion to shareholders via dividends, but with the company now facing massive losses, the rational decision would be to cut the dividend payout or to abandon it altogether until it is profitable again.
Under normal circumstances, dividend-paying companies enjoy healthy profit margins, stable earnings and free cash flows that far exceed capital expenditures. Intel, unfortunately, does not fit this description, which questions the rationale behind rewarding investors with dividends.
Following the announcement, Morgan Stanley (MS, Financial) analyst Joseph Moore upgraded his rating for Intel. He wrote:
"We have long said that we would prefer to see Intel as a value stock with optionality for a turnaround in the core business, but that the ramp of fixed costs created too much risk for cash flow degradation. With this [news] detailing the dividend cut, slight capex cuts, and further opex cuts, we see a management team that is now working to return to a more disciplined approach with regard to capital management and allocation.”
To successfully execute a turnaround, Intel will have to shift to a more efficient capital allocation model that promotes growth and investments in the business. A good first step is to cut back on shareholder distributions and reallocate the savings to reinvest, which is what the company is planning to do.
The rocky path ahead
Patrick Gelsinger, after being appointed as the new CEO in February 2021, announced the IDM 2.0 strategy in March, seeking to reorganize the business with a focus on reinventing its manufacturing capabilities, cultivating an innovation-oriented mindset among employees and focusing on gaining competitive advantages through product leadership. Some of the notable plans highlighted under this program include an investment of $20 billion to build two new fab plants in Arizona, the development of 7 nm processors and launching foundry services.
Another plan that received a lot of appreciation from market participants was the decision to use third-party foundries to design chips. Intel’s previous strategy of solely relying on in-house manufacturing capabilities led to market share losses in the years preceding 2021. To execute these plans, Intel will have to invest billions of dollars in the coming years, and the expected decline in Ebitda this year is proving to be a threat given that it will have an impact on free cash flow generation. Tapping capital markets to raise cash is an option, but such a decision will further deteriorate investor sentiment.
As recently as five years ago, Intel controlled almost 98% of the data center market, but it lost market share in this important segment to Advanced Micro Devices Inc. (AMD, Financial). As illustrated below, AMD’s market share in the mobile, desktop, server and client segments has grown steadily since 2017, while Intel saw its piece of the pie shrink.
Source: Tom’s Hardware
Gelsinger is not oblivious to these market share losses, but he does not believe a recovery is possible until at least 2025. Speaking at the Evercore ISI TMT Conference last September, he said:
"Competition just has too much momentum, and we haven't executed well enough. So we expect that bottoming. The business will be growing, but we do expect that there continues to be some share losses. We're not keeping up with the overall TAM growth until we get later into '25 and '26 when we start regaining share, material share gains."
An exmaple of this can be seen with its chips. While Intel is planning to launch 7 nm processors this year, AMD is way ahead of the competition with 5 nm processors. In the best-case scenario, Intel will continue to lose market share and take a hit on profitability through 2025. Even in that case, there is no guarantee the company will make a successful comeback. Investors, therefore, are betting on a future that is nowhere near certain.
Takeaway
By slashing the quarterly dividend, Intel is moving in the right direction to save much-needed cash to reallocate toward reinvestment. The company, however, has its work cut out to survive let alone thrive in the next few years. As such, the risk-reward profile does not appear to be favorable for investors today.
Although Intel seems too big to fail, empirical evidence suggests companies of every size can indeed collapse when they fall victim to competitive pressures. Being cautious when modeling future revenue growth for Intel seems to be the best course of action currently as the stock could be as much of a value trap as it appears to be a value investing opportunity.
