Companies must spend money to make money -- at least, that's what many investors believe.
The market has long followed research and development (R&D) and capital expenditures (or capex, for short) with the idea that companies making investments in these areas will see huge payoffs in revenue somewhere down the line.
When the increase in capex works out, investors are rewarded. The issue is that the market has a problem with timing the jump in future revenue. When the stock price bounces too early and the revenue is not there to support it, then shares retreat downward.
One major tech company is waiting for its recent R&D investments to pay off. I'm talking about Intel (INTC), the world's largest maker of computer chips, which is due to report its first-quarter earnings after the market closes April 16.
In January, Intel's shares dropped 6% after its 2012 fourth-quarter earnings report as management announced a nearly 20% jump in capex for 2013. But shares have since rebounded almost 8% as investors prepare for a payoff in revenue.
Short-term pain, long-term gain
Back in September, I argued that a 4.2% dividend yield and the cheapest valuation in a decade made Intel a huge "buy." Although the company has continued to hit short-term weakness, the upside potential I've outlined still applies.
And I'm not the only one who shares this opinion. My colleague Amy Calistri recently added Intel to her Daily Paycheck portfolio in March, noting that "Even if Intel's rebound takes a few quarters, patient investors will be paid well to wait."
Intel said it would have $13 billion in capex this year, an 18% increase over 2012 and well above the Street's estimates of $8 billion. Capital expenditures are taken off of income in the quarter they occur instead of being held on the balance sheet as an asset, meaning that the increase in Intel's capex will probably lead to lower 2013 earnings than originally expected.
Shares have been volatile through April, when the R&D myth started to take hold and the stock popped upward 6% on positive expectations for the first-quarter report.
The problem is that higher revenues will probably lag behind investor expectations considerably, and the shares could suffer in the interim. The mix of spending for this year is shifting to equipment, which has a longer development cycle and probably won't see a payoff until 2014 or 2015.
In February, Intel said it would begin production of configurable chips for Altera (ALTR). The project marks a significant departure from Intel's business model as a designer of proprietary chips to a high-end chip foundry for customers. The project carries significant scale in production, something Intel is capable of doing, but lower margins on pricing.
Investors have been positive on the deal, not because it will add much near-term income, but because it could lead to a foundry deal with Apple (AAPL). The foundry deal with Altera has a fairly long development cycle, so a payoff in the form of an agreement with Apple could be more than a year away.
So what does it mean for investors?
The short-term question really is: Have the increase in expenses and lower margins been built into Intel's stock price?
Investors see the Altera project as an opportunity for a deal with Apple, but they may not realize the implications of the current quarter's higher capex or the time it may take Intel to prove its foundry business. While the new line may eventually lead to a relationship with larger buyers like Apple, it is likely to be a money pit in the short term.
Long-term investors can feel comfortable with the 4.2% yield as they wait for a turnaround. Short-term investors may want to wait a few months. Intel has historically held about one year's worth of capital expenditures in cash on its balance sheet. It had $8.5 billion in cash at the end of the fourth quarter, so it will probably be adding to cash in this quarter. This means that while the dividend is almost certainly safe, Intel might not buy back as many shares as usual.
Intel is expected to post a 23% decline in earnings per share compared with the first quarter of 2012. Based on its history, Intel should have no problem beating the EPS estimate, but investors could still be disappointed if there is no guidance on the mobile or tablet businesses or a lack of progress in the search for a new CEO to replace departing chief executive Paul Otellini.
Risks to Consider: Intel is considerably underpriced and underappreciated relative to its lead in chips and future cash flow projections. Waiting to buy because of near-term weakness risks missing out on a big move to the upside on a positive headline, but long-term profits should still be available without the risk of a near-term drop.
Action to Take --> While I still like Intel's prospects in the long run, investors may be in for a rude awakening when Intel reports first- and second-quarter earnings that show significantly higher expenses and lower margins without any guidance on higher incremental revenues.
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