Intel had a profit warning at the start of August and suspended its dividend. The chance of any shareholder returns over the coming years are now low and we sold our relatively small holding on the day as one of the requirements for inclusion in the RGI Global Income and Growth fund is a 2% dividend yield on each holding. We lost money, and that is never a painless experience. It isn’t our first loss, and we know it won’t be our last. Every investment we make has the chance of a worst-case outcome. Without a full understanding of what happened, it can be a mistake to immediately equate a bad outcome with bad decision making. The purpose of this blog is to help understand why we were invested in Intel, what happened and what we have learned.
Why were we invested in Intel?
Intel’s plan of regaining market leadership appeared to be making progress, as reflected in the shares rising around 90% in 2023. There were signs of market share gains in notebook CPUs and a slow clawback in datacenter processors. The number of clients signing up to new products like 18A was a positive surprise. Trade reports of the new class of chips being faster than the competition, yet using less power, were also encouraging. Many external forces were also moving in favour of Intel’s chances. Both COVID and AI reframed the geopolitical risk of not having a domestic U.S. champion in semiconductor manufacturing. One of the big strategic errors that Intel made in the past in turning down ASML’s EUV technology was potentially being rectified by taking delivery of ASML’s first High-NA EUV tool.
If the plan worked, not only would sales start picking up, but a pathway to the longer term targets of a 60% gross margin and a 40% EBIT margin would start to become clear (although our forecasts were more cautious). The starting points were 40% and approximately 0% in 2023 respectively, a far cry from Intel’s potential.
We knew the plan was going to cost a lot and pencilled in higher capex outflows vs guidance and analysts. Despite this, we still expected leverage to come in below 2x net debt/EBITDA in 2024. This was based on 4% sales growth, gross margin of 46% and an EBIT margin below 10% for 2024.
We considered our base case assumptions to be conservative, with mid-single digit top line growth and annual margin expansion of around 3% over the next 5 years, leaving us 20% below consensus expectations. Even though we factored in lower growth and higher cash flow burn, the shares still looked attractively valued.
What went wrong?
Perhaps no other large American company has tried to change itself quite as drastically as Intel. This was badly needed after 10 years of underinvestment. It coincided with the industry experiencing a marked slowdown from extended demand during Covid. The mountain to climb was huge. We thought we had factored this in by including weaker demand from consumers and slower margin improvement. Due to the high execution risk and range of our worst-case estimate, we kept our position size low.
Nevertheless, our understanding of the worst-case scenario underestimated the margin impact from the ramp up of the new products, along with other unforeseen operational challenges e.g. the move of production of wafers to the higher-cost Irish facility. The operational cash needed for executing the strategic plan was much higher than we (or anyone else) expected. After Intel improved its margins each quarter throughout 2023 the decline in 2024 was a real setback. Some of this can be put down to missteps in the execution. We were aware of the operational leverage in the P&L and factored this into our worst -case scenario. Nevertheless, it turned out to be much higher than we expected. Put simply, turning around the company is going to cost more and take longer than our worst case anticipated.
What did we learn?
Turnarounds take time. Especially when they are implemented after a decade of underinvestment. They can work out very well for investors (GE and Rolls Royce being good examples) but knowing when they are on, or off track can be hard. And many don’t turn around. In this case we were caught out by the early promising signs of quick technological advances and financial improvements. However, we underestimated the executional risk on the long road to recovery. Nothing ever goes up in a straight line, and we are willing to be patient. Even with tremendous asset value underpinning the valuation, Intel’s required additional investments, resulted in no line of sight to healthy returns on capital or surplus cash flow.
Due to the execution risk and high cash needs for the coming years our Value Trap Analysis flagged a deterioration. Consequently, we lowered our position size when in retrospect we should’ve sold the position entirely.
Our process will not change. We will continue to invest in technology companies and will continue to consider turnarounds. However, this experience raises the bar for future inclusion and again emphasises that the range of possible outcomes can be wider than you might reasonably consider.
KEY RISKS
The value of investments and any income generated may go down as well as up in response to general market conditions and the performance of the assets held, and is not guaranteed. An investor may not get back the amount originally invested.
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