In my last few posts on Intel, Microsoft, and their competitors, I promised to share my valuation of each of them. But first, I can’t stress enough the importance of considering disruptive technologies, especially when valuing technology investments.
As an investor, understanding risk is more important than focusing on potential returns. It is too easy to lose a dollar but still hard to make one. Therefore it only makes sense to focus on protecting your downside. This is especially important in the ever-changing, fast-paced world of technology because the future is especially uncertain. The Internet has changed the way we live and the way business operates. It has been massively disruptive to many old world businesses. The resulting change has been great for consumers and is simply part of the natural life and death cycle of capitalism. One prime example of this is Pitney Bowes (PBI), the maker of postal equipment. Because of the way the Internet has changed the way we communicate, even with a 7.3% dividend yield and forward earnings yield of 11%, I wouldn’t touch PBI with a 10-foot pole. The downside risk is immense for the same reason that the US Postal Service is insolvent.
I agree with the pundits that technologies like Cloud computing could have a similarly disruptive effect to the tech titans of today as email has to PBI. In a world where computing resources (apps, data, computing power, etc…) are on the “cloud”, I can easily imagine a world where all most of us need are minimalist (whether mobile or at a desk) devices that can access the cloud. This world, which is not too far off in the future, is one that eliminates the need for most PC’s and can severely disrupt the existing business models for companies like Intel and Microsoft. Microsoft would no longer be selling licenses for Windows and Office for individual machines but rather charging a fee per use of their cloud service (which they are beginning to do with Office 365 and Windows Azure). My point here is not to speculate on what the future holds but rather to point out that you have to take this type of scenario into account when valuing some of these companies to assess whether there is enough margin of safety (minimal risk of losing your money) to deem them prudent investments.
So with that rant, let me go into my first-pass valuations for Intel, Nvidia, Analog Devices, and Taiwan Semiconductor.
Intel (ticker: INTC)
Seeing Intel’s seemingly low valuation, high dividend yield, and strong balance sheet is what started me down this path of looking at technology companies so let me start here.
As of today (10/25/11), Intel’s market value (net of their healthy net cash position) is about $120 billion.
If we simply extend Intel’s trend sales growth (4.3% since ’06 or 5.1% since ’01) and net profit margins (17% on average) I come out with a value of approximately $100billion. So on this metric, Intel is 20% OVERVALUED. Therefore, markets are expecting some combination of higher sales growth and/or higher margins than we have seen historically … in spite of the tremendous competitive pressures from ARM licensees, the demise of the PC, etc…
Often times it pays to simply take a longer term perspective and look at a business’ performance during both good and bad times. The investing world is so focused on the short-term that it appears they are assuming Intel’s recent profit margins (25% in 2011) and sales growth (24% in 2011) will continue indefinitely. But we are in the middle of a PC refresh cycle and the global economy has seen solid growth in the past 2 years. So we can’t assume this will always be the case.
I don’t need to dig too much more into the numbers to know that there is no margin of safety with Intel right now. If Intel can’t successfully break into the mobile devices world, who knows how low their valuation could go.
Nvidia (ticker: NVDA)
As I explained in a previous post, Nvidia is a competitor of Intel’s in the graphics processor space but is also trying to break into the PC and server space as well by licensing processor cores from ARM. Nvidia has a lot of potential if they can succeed, but that’s a big if. Let’s see what the valuation looks like.
Currently, Nvidia’s market value (net of their healthy net cash position) is about $6.6 billion. If we follow the same starting point as we did for Intel by simply extending their historical revenue growth rate (10% since ’01) and net margins (7%) I get a valuation of $5.3bln. If I bump up the net margin assumtion to 10% (similar to what they achieved in their best years), I get a valuation of $7.5bln. Clearly the expectation is for them to succeed in an increasingly competitive arena.
In addition, I always like to look at return on invested capital for any business. If a business model can’t earn at least 10% return on capital (preferably 15%) then I should not expect it to deliver a good return to shareholders in the future. Nvidia’s incremental ROIC from 2001-10 is only 6%. You can’t return money to shareholders if you’re not generating any above the cost of equity capital. I don’t like my prospects with Nvidia either.
Analog Devices (ticker: ADI)
Let’s look at Analog Devices next as a parallel player in the semiconductor industry. They too are in a space that will likely grow; supplying ADC chips to wide variety of industries including building automation, industrial uses, automotive systems, mobile devices, and healthcare to name a few. And ADI as a leader in this space is poised to benefit from this growth.
ADI’s market value (minus their net cash position) is about $8.2 billion today. Their annualized sales growth has been under 2% over the last 10- and 5-yrs respectively. Even if I generously assume their operating margin growth (of 5.7% since ’01) will continue into the future along with profit margins of 18% (avg since ’06) I get a value of only $6.7bln. We all know margins can’t grow faster than sales indefinitely so this is generous and I still find them to be slightly OVERVALUED.
All of these companies look “cheap” using superficial metrics such as P/E ratios and dividend yields but all of them are priced for successful futures. Where is the margin of safety for when (not if) things go wrong?
Taiwan Semiconductor Manufacturing Corporation (ticker: TSM)
TSMC is an interesting company and one I have known about going back to my days as a semiconductor engineer. They are the largest player in the increasingly consolidating semiconductor foundry space. There are only 4 main players left including UMC, ST Micro, Global Foundry, with TSMC being the largest by far (owning some 45+% of the semiconductor manufacturing market in 2010).
TSMC also has a positive net cash position and, net of this amount, their valuation today is about $60bln. Their historical sales and net margin growth has been high (14% and 28% respectively) since 2001, and profit margins have averaged 28% (and trending upwards) since then. Using the sales growth and historical margin numbers for valuation, I get a business value of $70bln. About 15% UNDERVALUED. Assuming numbers more like others expect of industry growth of 12% and more recent historical margins of 32%, I come out with a business value of over $93bln or a 35% DISCOUNT.
It’s also worth noting that TSMC has a ROIC of 17% (and incremental ROIC of 44% since 2001) in a capital intensive manufacturing industry. They also have a conservative balance sheet (as noted above), are an industry leader, and are branching out into LED’s and solar panels. There are plenty of business risks as I explained earlier but they have a lot of competitive advantages including manufacturing prowess, a customer base that includes the main ARM licensees and Intel, and the capital to stay this way.
Now this is a business worth looking into further.
In Summary …
Even with low P/E ratios of ~10, above average dividend yields, and fortress balance sheets, most semiconductors companies (as shown by the samples above) appear closer to fairly valued than not given the risks as described above and in previous posts. There is simply not enough margin of safety to invest in Intel, Nvidia, and ADI. Ofcourse I may be wrong and Nvidia may come to dominate the computing market but that’s a gamble. You can take your money to a casino or stock market technician for that.
Taiwan Semiconductor looks interesting for a lot of reasons. But this post is getting long enough. So I will take deeper dive into them and also look at valuations of Microsoft, Cisco and others in the near future. Stay tuned.
Comments
Is your 10-15% target for ROI a strict rule? For all industries? I recall there are some businesses with good competitive moats, such as RBA, that do not meet this criteria, for example.
This is a good question so I’m going to use it to comment on both ROI and the discount rate used in the NPV calculation.
First and foremost I don’t want to be overly precise with any of these numbers because doing so can give you a false sense of precision in an investing world that is rife with uncertainty.
That being said, the ROI of a company should be above their cost of capital for shareholders to expect to receive an above average return. So, as we learn in textbooks, you calculate this as a weighted average of the debt and equity costs of capital (COC). For a company with high levels of debt (especially in today’s low rate environment), their COC will likely be lower than 10%. But I generally don’t like those companies with high levels of debt to begin with.
The discount rate I use, which is the same as the equity cost of capital, is based on my long-term expectations for equity cost of capital (since I am a long-term investor). To me, the discount rate breaks into two components:
1) risk free discount rate
2) equity risk premium
For the first, I assume that the long-term growth of the economy is around 3% and the long-term rate of inflation has also been around 3%. So an appropriate long-term risk-free rate is about 6% (even though today it is closer to 2%). And then I add an equity risk premium of 4% (this is what it has been historically) to arrive at 10%. This is the absolute lowest number I use to stay conservative. For riskier businesses I will use slightly higher values.
But again, I don’t care to be overly precise with my discount rate. If an opportunity has a 40% margin of safety with a 10% discount rate, it will have a similarly large cushion with a 12% discount rate.
I hope this helps.
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