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Investment Thesis
In light of recent US government grants for domestic chip production, I believe Intel (NASDAQ:INTC)’s foundry business is expected to be a key factor in their future growth and currently underappreciated. Intel’s fabrication unit is starting to capitalize on the semiconductor industry’s shift towards supply chain diversification by bringing together desired supply chain rigidness from customers with brand new 18A technology from Intel. By using its soon-to-be-produced advanced 18A process node, Intel may be able to overcome TSM’s current dominance on the market. Intel Foundry Services (IFS) has seen substantial growth, with revenue increasing by 63% year-over-year as of Q4 2023.
To help accelerate growth, Intel has teamed up with other tech giants and chip manufacturers, in order to improve quality of production and drive out competition. With the backing of initiatives like the CHIPS Act in the US, domestic chip production is on the rise with Intel benefiting. Given these dynamics, I believe Intel’s foundry business is set to benefit immensely from the expanding market demand, helping the company find a strong position in the fabrication of semiconductor chips. I believe the stock is a strong buy.
Why I Am Doing Follow Up Coverage
Since my last piece on Intel, the company’s stock has fallen 9.1% as a result of a Q4 report where investors did not like the strength of the current quarter’s guidance and now a Chinese government ban on using Intel technology on any of their government computers.
In my opinion, I think this is overdone and recent developments with their Fab business are more what needs to be watched. I believe that both concerns since my last report (the Q1 guidance and Chinese chip ban) both have little effect on the long run of the company especially given the potential of AI chips that I gave last time coupled with the core strategic value proposition that Intel’s foundry business brings for its customers: supply chain diversity away from countries geographically close to China (Taiwan). In addition, the recent release of government funds show continued national security interest in solving this supply chain diversification issue.
Background
Intel’s foundry sector is set to be a key opportunity for growth in the coming years. Companies within the semiconductor market are looking to diversify their supply chains as a result of geopolitical risks with China (they could invade Taiwan) and due to industry concentration to one supplier. In order to do this, they must move some of their reliance away from Taiwan Semiconductor Manufacturing Company (TSM), the largest semiconductor foundry by global market share.
By doing so, this opens the door for Intel’s foundry business to capture a larger market share. Intel’s goal is to surpass TSM and gain technological leadership by early 2025 hinges on the successful deployment of their 18A process node. The Intel 18A process node is a manufacturing process that aims to make smaller and more energy efficient semiconductors, thereby making their manufacturing more appealing to customers. Many of Intel’s current manufacturing processes lag behind TSM’s capabilities meaning companies that need the most advanced and modern semiconductors have no choice but to turn to TSM.
Intel’s Foundry Services, outlined in early 2021, aims to become the world’s second-largest foundry by 2030. This division has experienced significant growth, with revenue increasing by 61% year-over-year in the fourth quarter of 2023. Within this sector, Intel has collaborated with firms like Arm, Ansys, Synopsys, Cadence, and Siemens to provide them access to advanced tools, design flows, and intellectual properties to catalyze customer-driven designs.
In order to expand their foundry business further and increase partnerships, Intel has invested in foundry services across the U.S. and Europe. These efforts are supported by favorable political and economic landscapes, including incentives like the CHIPS Act in the US. The CHIPS Act, which places the focus back on US manufacturing for national supply chain security, may help Intel climb their way back to the leading manufacturer and regain market share. We’ve seen a recent rise in global incentives for onshore chip manufacturing because other countries also want to add more national security and stability to their supply chain. Intel is able to ride this wave.
Q4 Report
In the fourth quarter earnings report, Intel’s Foundry Services (IFS) showcased significant progress, with a notable design win for its new high-performance computing customer, marking the fourth external Intel 18A customer victory in 2023. The results of this last quarter reflect Intel’s growing customer base and success based on the 18A process node. So far Intel has over 75 ecosystem and customer test chips taped out and plans for over 50 more in 2024 and 2025 (Q4 Call).
Intel’s financial performance in the foundry segment was impressive, with IFS generating $291 million in revenue, a 63% increase year-over-year, and annual revenue reaching $952 million, doubling from the previous year.
Not only are the numbers impressive, but this earnings call showcased the advancements made in the actual production process. On the call, CEO Pat Gelsinger stated that in 2023, Intel gained more than “40 strategic agreements across EDA design services, IP, cloud, and U.S. military aerospace and government.” Operating margins dipped lower, with margins dropping from -19% in Q4 2022 to -39% in Q4 2023 but this is due to sustained capital investments (Q4 Earnings Presentation).
As more focus shifts towards supply chain sustainability in mass production, Gelsinger insured consumers the importance of supply chain sustainability to the company. In fact he stated that Intel is the only semiconductor producer “with sustainable manufacturing in every major region of the world providing ourselves and our foundry customers’ resilient access to the right capacity in the right regions at the right time.” On top of this, the launch of Intel 3 as the first advanced node for IFS provides customers access to cutting-edge manufacturing processes. On the call, Gelsinger also mentioned the company’s goal of five nodes in four years is likely to be completed in the second half of 2024 as the Intel 18A will be ready for manufacturing.
Key Wins & Government Incentives
The U.S. and European political landscape has been increasingly supportive for Intel, as they have recognized the importance of semiconductor production. In 2022, the US government passed the CHIPS Act which allocates $280 billion to semiconductor chip spending over the next 10 years. This act also provides semiconductor manufacturers with a 25% investment tax credit towards equipment. This act has been especially beneficial for Intel, as it increases their domestic manufacturing capabilities, thus relying less on foreign chip production.
The increase in regulations on chip importation and exportation to China, such as the recently imposed restrictions Nvidia faces, could potentially redirect business towards Intel’s foundry services. These restrictions, while meant to prevent the development of technology in China, may lead to an opening in production that Intel is set to fill. For reference, China’s biggest foundry, SMIC, had 6% global market share as of last December. I believe their orderbook of international demand is up for grabs given these restrictions that make it harder for SMIC to get the technology they need to export chips
On top of this, Intel is starting to capture key wins in the US that act now only as anchor pieces of business, but also a statement on the quality of their new fab business. The confirmed collaboration with Microsoft is set to help Intel reach new areas of the market and grow their influence in the semiconductor sector with Microsoft implicitly blessing the quality of Intel’s chip fabrication process. These partnerships may be the key for Intel to surpass one of their biggest competitors, Samsung, which is the second-largest global provider in foundry and chip packaging services.
Intel has also been participating in other types of partnerships: ones that go directly for the competition, Nvidia for their GPU business. Intel has teamed up with Qualcomm and Google, forming a group called UXL Foundation. In the near future, they hope to recruit other chip companies that want to design their own chips such as Amazon Web Services. Currently, Nvidia dominates AI GPU foundation software through its program CUDA which runs exclusively on Nvidia GPUs. This organization aims to create tools and software that can power a wider variety of AI software chips. By doing so, they allow developers to work with companies other than Nvidia. In exchange, this helps broaden who’s chips are used in data centers. This in-turn, helps Intel propel potential chip design customers who may wish to use their fab facilities.
Valuation
When I last wrote about Intel in December, I wrote about how Intel is working on chips that help enable edge computing for AI. Since then the company has worked with companies like Google, Microsoft and Qualcomm to attempt to disrupt Nvidia’s CUDA creating more opportunities for their own AI chips and for other companies that may wish to use IFS services.
While this (along with the developments with IFS) are all positive developments, the lower potential sales resulting from a more tepid Q1 guidance and now a sales ban in China does make me understand why investors have punished the stock since I last wrote about them. But, I see these are short term concerns given what I see as the highly reasonable valuation Intel currently trades at.
Previously, I wrote that I thought the fair value was 44.1% higher than the stock price at the time, implying a share price of $70.89/share.
To be clear, I still think the company has strong upside from here, especially given the fact that these shares have now fallen 9.1% since the last time I wrote.
As an example, the company scores a sector median rating of an ‘A-’ for its forward price to book ratio of 1.71, a 59.16% discount to the sector median, an ‘A-’ for their forward price to cash flow ratio of 12.35 which is 46.73% below the sector median of 23.19 and a ‘B’ on their forward PEG ratio of 1.29 which compares to the sector median of 1.94 (a 33.84% discount).
In essence, the firm scores well on many factor-analysis metrics. I believe that if we average these discounts that reflect the different multiples the stock trades at we get an average discount to sector median of 46.58%. Given this, if Intel converges on the sector median, we could see 87.18% upside to the share price, implying a share price of $83.29/share.
However, to address some investors’ concerns, I’ll add a reduction to this given that Intel has recently learned that their chips sold in China could see their demand drop by up to $1.5 billion annually. After applying the company wide forward price to sales multiple of 3.22 to this, we get a market cap discount of $4.83 billion, or about a $1.14/share discount given that the company has 4.23 billion shares outstanding right now. Given this, my target share price is $82.19/share.
Keep in mind, this is still far below the forward price to sales of the fab leader (TSM) which trades at a forward price to sales multiple of 7.56. In essence, as Intel begins to show the market more details of their new fab unit accelerating, I believe this will allow the market to rerate the stock higher (per my valuation analysis above) but still below the forward price to sales multiple of their biggest fab competitor.
Why I Upgraded My Price Target
While Intel does face headwinds related to sales in China, it’s worth noting that after applying these metrics, the impact overall to share price is minimal. I think this is a testament to the diversification to the company’s business and the significance of the development efforts they have. These new foundry initiatives (on top of what the company already is doing with AI chips) are powerful for the future.
Risks to Thesis
Intel’s foundry business still carries several risks to be mindful of. Rumors of Intel using TSM for some Arrow Lake Compute Tiles. This could be seen as a lack of confidence in their own manufacturing capabilities. In order to secure the public’s trust, Intel needs to be transparent about these collaborations. To do this, I believe it may be wise for Intel to discuss the reasoning of the partnership or temporary use of TSM’s service while Intel builds their own advanced process nodes like the 18A.
A market wide slowdown in the AI PC sector also presents as a risk to investors, particularly as this would affect Intel’s traditional revenue streams. In the past the PC segment has been a large part of Intel’s revenue, meaning that a decline could result in cascading effects on the financial health and investment possibilities of Intel’s foundry business. If Intel is able to diversify their revenue streams, such as in areas like data centers, AI, autonomous driving, and 5G networks, they would be able to counterbalance any weaknesses in PC demand. In this case I’m not super concerned. I believe we are about to see an acceleration of new PC demand driven by increased AI PC upgrades. Intel will be able to benefit from this directly through the sales of their new AI CPUs that I talked about in December, and indirectly through their IFS business.
Recent news about China plans to ban the purchase of chips for government use from companies such as Intel and AMD could definitely be a risk. Currently, roughly 27% of Intel’s chip sales are based in China, some predicting this ban could cause Intel to lose as much as $1.5 billion in chip sales. While this may seem alarming, I believe Intel’s foundry business has little itself to worry about. Although the company as a whole may lose a portion of their revenue stream, domestic production incentives implemented by the CHIPS act and advancements in manufacturing technologies will attract more companies to use Intel’s foundry business as their producer. On top of this, the increase in demand for other AI PCs is on the rise, thus counteracting their loss in sales. And, as I mentioned in the valuation section, even if this revenue is not replaced, given the current price to sales ratios, I believe this will have a minor impact on the fair value of Intel stock.
Bottom Line
I believe after a deep dive of Intel’s foundry business (IFS) the company is on the right track in ways where I think they can win market share and help their stock price. The company’s foundry business is poised to redefine their market position and take advantage of the changing manufacturing preferences of the semiconductor industry (on-shoring manufacturing). By implementing new technologies such as their cutting edge 18A process node, they stand a good chance to compete with TSM and even leapfrog Samsung as the 2nd largest chip fab. Intel’s substantial year-over-year revenue growth within the Foundry Services segment, combined with their partnerships with other semiconductor businesses, and the effect of the CHIPS Act, creates a solid foundation for expansion and in my opinion validates the strength of demand for their products. Keep in mind, this unit is only 3 years old and is already running at a $1 billion run rate. I think that’s impressive.
While the company is facing external risks like a ban on certain uses of their chips from China, I think this will be noise in the long run. As CEO Patrick Gelsinger has said, the future of the company is riding on this division. I am optimistic. I think the stock continues to be a strong buy.
