RATIONAL REFLECTIONS
By Bell Institutional
The Penthouse vs the Outhouse
In September, we covered how an investor can use stock prices and the concept of thinking backwards to obtain better investment performance. We argued that stock prices can be used to gauge the market’s current expectations for operating performance. With defined future expectations in hand, an investor then can determine whether those expectations are likely to be met or not. To expound on this concept in further detail, we will compare Intel, a company that has lost investor favor, with Nvidia, a company that is the darling of AI.
Potential Turnaround or a Sour Grape? A Look at Intel’s Future Prospects
Much has been made of Intel’s fall from grace in recent years, given its former place at the top of the mountain. The company has faced criticism for its product roadmap, manufacturing challenges and perceived lack of innovation.
As a quick background, Intel was founded in 1968 and quickly became a pioneer in the microprocessor industry. Intel developed the x86 central processing unit (CPU) in the 1970s that emerged as the instruction set required for IBM PCs and, later, Microsoft operating systems. For many years, effectively all PC software was designed for the x86 architecture, and software makers could not easily deviate from building x86optimized applications. Intel’s dominance was further solidified by its adherence to Moore’s Law, which states that the number of transistors on a microchip doubles approximately every two years. This allowed Intel to consistently release faster and more powerful processors, maintaining a significant technological advantage over competitors.
Given Intel’s then lead in manufacturing capabilities, customers often were forced to “take it or leave it” when buying chips. Unfortunately for customers, they didn’t have much of a choice. This inability to work with customers came to a breaking point in 2005, when Intel lost out on (or passed on, depending who you ask) building chips for the iPhone.
Intel’s revenue growth has been sluggish since the iPhone debuted in 2007, with an average of 2.7% annually. However, the factor recently driving Intel’s price downward has been its manufacturing miscues,¹ which have resulted in margin compression. Specifically, operating margins started to fall off a cliff in 2022 (ChatGPT was released in November 2022) as the company has been unable to effectively ramp production for its AI products. Intel’s second-largest segment is Intel Foundry, which physically manufactures semiconductor chips. A foundry incurs large fixed costs which result in high amounts of leverage. If a foundry does not have sufficient
demand, losses mount. The continued manufacturing miscues at Intel have resulted in an inability to ramp production and lost demand. Over the first three quarters of 2024, Intel Foundry has posted GAAP operating income of -$11.2 billion. Ouch!
Looking Forward
*Adjusted for R&D expense
While recent history has not been kind, stock prices are dependent on the future, not the past. Is it likely that Intel returns to its dominant market position or finds the fountain of youth? No. Have competitors such as TSMC, AMD and Nvidia taken large swathes of market share? Yes. While it is easy to be negative, it behooves investors to acknowledge the other side of an argument as well.
Intel has some serious tailwinds going for it, the largest being the U.S. government’s attempt to onshore semiconductor manufacturing. This has resulted in Intel being awarded $8.5 billion in funding from the U.S. CHIPS Act in addition to $11 billion in federal loans, with more funding likely to come in the future. The other large tailwind for the company is that the AI semiconductor market is continually expanding, and Intel is one of the few companies with a diverse enough portfolio to serve a large portion of that market.
From the current stock price, we can see that the bar has been set fairly low. (Intel reported earnings on 10/31 that were merely “better than feared.” The stock saw a price impact of +7.8% in trading the next day.) If Intel can boost its manufacturing performance, ramp up production and secure additional demand (Intel and Amazon recently announced a partnership²), future performance likely will be favorable. Specifically, if Intel is able to get its margin profile back to that of the 2010 – 2021 period, there should be material upside. If Intel continues to blunder and burn through cash, the stock price is likely to continue its downward spiral. A cheap stock can always get cheaper. For reference, if Intel only increases its operating margin to 25% over the next five years, a compound revenue growth rate of 6% would be required to maintain the current price.
Intel was trading for $23.20 on November 1.
Source: FactSet
The King of the Mountain: Nvidia is Unstoppable, Right?
Sometimes the best thing you can do is be in the right place at the right time. Nvidia, founded in 1993, originally focused on developing 3D graphics accelerator cards for personal computers. The company later introduced the Compute Unified Device Architecture (CUDA), which was a platform that allowed developers to use GPUs for tasks beyond graphics. Nvidia had built a substantial lead on its competitors in the GPU space, but the problem was that there weren’t any great (high revenue) use cases for GPU chips. It was a big player in a relatively niche market. However, when ChatGPT was released in November 2022, that changed. GPUs provide the computational power and efficiency needed to train and deploy AI models, and Nvidia was in the perfect position to benefit. Since then, the hyperscalers have been in an all-out arms race to purchase as many GPUs as possible, spending billions each year building out datacenters. This has resulted in revenue growth reaccelerating and margins expanding to levels that would make any company jealous. In 2022, operating margins were 36.9% and have expanded to 67.8% over the last 12 months. Not bad!
Source: FactSet
However, as a general rule, where one company has success, others are likely to follow. Companies such as AMD currently have competitive (albeit not quite as good) offerings that continue to improve. Big tech has also taken notice, with Apple, Meta, Amazon and Google developing their own custom chips. Additionally, there are new startups such as Groq and Cerebras that have released chips dedicated to inference³ efficiency, as energy needs continue to increase.
Looking at the expectations built into Nvidia’s stock price, we can see that expectations are high, the margin for error is thin, and investors continue to expect more of the same operating excellence. To be sure, Nvidia is still the undeniable leader in the house with a commanding market share (popular estimates assume 90%) in a market that continues to grow at high rates. If the company can fend off the competition (and maintain current margin levels), there is still clear upside. Operating margins averaged 39.6% from 2017 – 2022. If Nvidia’s margins were to fall back to more recent historical levels, serious growth would be required. For reference, if operating margins were to drop to a more normalized level of 40% over time, compounded revenue growth over the next seven years would need to be roughly 25% to maintain the current price. This is after the 195% revenue growth over the last 12 months. Notice how we are using a seven-year period for Nvidia as opposed to five years for Intel. Operating excellence is required for longer!
*Adjusted for R&D expense
Source: FactSet
Decision Time
Using prices to determine required operating performance can be a useful thought exercise when evaluating a stock. When it comes to the companies mentioned in this piece, we see a dichotomy in expectations. Intel has a very low bar, and investors should require only a few things to go right in order to develop a thesis that results in a buy. However, the company continues to be unable to get out of its own way. Pulling off a “turnaround” is notoriously difficult. On the other hand, Nvidia has expectations that are much higher with only a small window for error. A high level of execution has been the norm and is required going forward. If the company can continue marching along with relatively little competition, the price looks right. If an investor believes Nvidia is likely to slip up in the future or the AI market is not as large as it is currently made up to be, then it is best to stay away.
Whether an investor buys, sells or holds, determining what future performance is currently built into a stock should be a cornerstone of any analysis.
Keeping the Feedback Loop Open
It is entirely possible that you disagree with a variety of the assumptions in this article. Rather than dismiss alternative analyses as wrong, we are better served by keeping our feedback loop open. If you would like to share your opinion and/or critique ours, please feel free to share your thoughts. One of the great aspects of investing is that if you get something wrong, you always have the opportunity to change it. Refusing to change a narrative, just because it is yours, is nothing more than hubris.
Jordan Bancroft, CFA, CAIA® VP/Portfolio Manager
jbancroft@bell.bank
End Notes
¹Recent miscues include Intel’s 18A manufacturing process failing to meet expectations, not adopting EUV lithography and CPU crashing issues in 2023.
²The partnership calls for Intel to produce an AI fabric chip for AWS using the Intel 18A process node, which is expected to improve performance and energy efficiency.
³This is the process of using a trained model to make predictions or classifications on new data.
Disclosures
This communication reflects the personal opinions, viewpoints and analyses of the Bell Institutional Investment Management (BIIM) employees providing such comments, and should not be regarded as a description of advisory services provided by BIIM or performance returns of any BIIM client.
The views reflected are subject to change at any time without notice. Nothing in this communication constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.
Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. BIIM manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
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