Intel – A Bond's Downside And A Stock's Upside?

Intel (Nasdaq:INTC) still has a long road ahead of it to regain the love of tech investors who believe that the core PC market is in permanent decline and that rivals like Qualcomm (Nasdaq:QCOM) and ARM Holdings (Nasdaq:ARMH) are still too far ahead in the expanding mobile market.

The concerns about Intel – revenue growth potential, cost structure, capital spending needs – are valid, but should also be viewed in context. Even though Intel is currently converting revenue to free cash flow (FCF) at a historically poor rate, it's generating more than enough to pay its dividend and fund ongoing buybacks. I wonder, then, if investors should approach Intel from the viewpoint that the downside scenario sees Intel grinding along with a bond-like total return, but with the potential upside of a more equity-like return if the company's efforts in mobile and foundry pay off.

First Quarter Results Only Decent On A Relative Basis
I sometimes wonder if investors get so obsessed with a company's performance vis a vis sell-side analysts that they sometimes forget to step back and look at results on their own merits. To that end, while Intel did meet the sell-side targets for top and bottom-line performance, the results really weren't what I'd call good.

Revenue fell almost 3% from the year-ago level and nearly 7% from the fourth quarter. Performance was pretty much evenly bad across the board, as all the major units had mid-to-high single-digit revenue declines on a sequential basis. That said, relative to the overall PC market, Intel's PC chip business did appear to outperform.

Margins were not particularly good. Gross margin fell almost eight points from the year-ago level and two points from the prior quarter, as inventory write-offs and lower utilization hurt. Operating income fell by nearly one-third, and the nearly 10-point drop in operating margin (three and a half points, sequentially) was one point steeper than expected. While Intel only missed its average EPS estimate by one cent, that was due to a lower-than-expected tax rate.

SEE: How To Decode A Company’s Earnings Reports

Plenty Of Challenges Left In Mobile
Clearly the biggest talking point on Intel remains its ability (or inability) to transition from dominating the PC chip space to becoming a major player in the mobile market. Some argue that it's just a matter of time, that Intel was slow to recognize the transition, but that the company's R&D and manufacturing capabilities will eventually close the gap with the likes of Qualcomm, Broadcom (Nasdaq:BRCM), and ARM's licensed technology.

Maybe that's true. Certainly Intel has a manufacturing advantage that its most direct mobile rivals (other than Samsung) do not. But I wouldn't underestimate the challenges. Intel has been flummoxed in trying to match ARM's power efficiency, though recent Intel chips have been better. I also wouldn't underestimate the reticence that some mobile players may have about letting Intel back into the game – everybody saw how Intel and Microsoft (Nasdaq:MSFT) dominated the PC market, and I don't think Samsung, Apple (Nasdaq:AAPL), LG, and the others want a replay (though you could argue ARM's design market share is just old wine in a new bottle).

Adapt Or Die
Barring a major leap forward that puts Qualcomm and/or ARM on its heels, Intel has to accept that the road forward is quite a bit different than the one that brought it here. As chip companies go, Intel hasn't been all that great recently at generating cash flow, and I'm not sure the Street is sold on the company's foundry aspirations (though I view it more as a means of subsidizing the cost of staying on the bleeding edge of manufacturing capabilities). At a minimum, investors should expect a steady drumbeat of criticism and heckling regarding the company's cost structure unless/until the mobile market share improves.

SEE: A Primer On Investing In The Tech Industry

The Bottom Line
Intel is in a tricky spot from a valuation perspective. Free cash flow margin is quite low now, and if the company cannot improve it beyond the mid-teens it's hard to argue that the stock is really exciting from a capital gains perspective. Even an eventual return back to the 10-year average free cash flow margin of 20% only suggests a fair value in the neighborhood of $25 unless the company can reignite revenue growth.

Here's how I view Intel today – it's a hybrid bond with stock-like upside. If Intel “is what it is”, I think the company will continue to generate significant cash flow and pay a hefty dividend. To me, that suggests a bond-like downside. If, however, the company can reignite growth through a stronger push into mobile (and/or more success in the data center), that bond-like floor will also see a meaningful capital appreciation kicker that should result in appealing total returns.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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Stick With “Bond-Like Stocks”

With the recent rout in various commodities and global growth concerns now creeping back into the headlines, investors are understandably getting nervous. After all, it was only a few years ago that the Great Recession took hold. With that in mind, U.S. Treasuries have once again become the asset class du jour as investors flocked to funds like the iShares Barclays 7-10 Year Treasury ETF (NYSE:IEF).

However, with yields on fixed income investments such as bonds, CD's and money market funds painfully low, they offer now real solace to investors looking for any sort of return. Luckily, investment bank Barclays (NYSE:BCS) has some other advice for investors to weather any approaching storm- dividend stocks.

Dividends, Dividends, Dividends
According to a new research note from the British bank, stocks that pay steady and rising dividends are the place to be as worries about the health of the global economy begin to take hold. Barclay’s notes that “stocks in the sweet spot of monetary policy- high quality, high dividend yield, low volatility- are supporting the broader market.” A group of four sectors- including healthcare, utilities, energy and financials- are each outperforming the S&P 500 by a wide margin month over month. The bulk of that outperformance has come from the group’s dividend payments.

SEE: Why Dividends Matter

There’s certainly a method to Barclay’s madness.

Dividends can help smooth out returns as these payments can help cushion the downside in falling markets. Reinvesting those payments can help enhance returns when the market rights itself. According to data compiled by Ned Davis Research, over the last 36 years, dividend stocks have outperformed the rest of the S&P 500 by 2.5% annually. More importantly, they outperformed non-payers by nearly 8% each year.

Blue chip stocks with strong corporate balance sheets and cash flow are already paying much more than treasuries. Yet, companies with a history of raising payouts are especially warranted. Unlike a bond which pays a fixed rate, with stocks you could potentially get a higher dividend year after year. Yields on the 10-year Treasury bond recently fell below 2%. When accounting for inflation, that equates to a less than 0% yield.

Overall, Barclay’s predicts that these “Bond-like Stocks” will continue to outperform over the longer haul and over the next few months as global growth concerns could come to fruition.

SEE: Banking On Blue Chip Stocks

Finding Those Bond-Like Stocks
With market volatility rising, now could be the best time for investors to add strong dividend payers to a portfolio. One of the best choices could be the Vanguard Dividend Appreciation ETF (ARCA:VIG). The fund is an index of stocks that have raised dividends over the last 10 straight years. The fund’s holdings- such as Coca-Cola (NYSE:KO) and Chevron (NYSE:CVX) -are exactly the kind of companies that Barclays is talking about. These large-cap names with strong global footprints are most likely to provide sustained growth during troubled times. VIG has a rock bottom expense ratio and currently yields 2.17%.

Another broad buy could be iShares Dow Jones Select Dividend Index (ARCA:DVY). The fund tracks a basket of dividend stocks. However, the iShares fund is bit more concentrated at 101 holdings and focuses more on current yield rather than dividend growth. As such the ETF produces a 3.93% dividend. Expenses are higher for the fund at 0.40%. Similarly, investors looking for more global muscle from their dividend investments could use the iShares Dow Jones International Select Dividend Index (ARCA:IDV). This ETF follows an analogous index to DVY, but shifts that focus to firms located outside the U.S.

Finally, one of Barclay’s biggest recommendations for investors looking for bond-like stocks is in the utilities sector. Even in times of uncertainty, consumers, businesses and municipalities still need to power their operations and cool their homes. Water still needs to flow and electricity hums through power lines. That makes firms like American Electric Power (NYSE:AEP), Consolidated Edison (NYSE:ED) and DTE Energy (NYSE:DTE) powerful dividend payers through thick and thin.

SEE: Trust In Utilities

The Bottom Line
With concerns about the global economies health, investors are once again facing a quandary- how to balance portfolio growth with safety. Luckily, they have a powerful tool at their disposal. By betting on large-cap stocks that pay healthy growing dividends, portfolios should be able to navigate whatever the market throws at them.

At the time of writing, Aaron Levitt did not own shares in any companies or funds mentioned in this article.

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