Is Intel a Value Trap? And One Way to Hedge

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you are looking to get into the chip market, it is important to consider how companies have done relative to one another. Over the last six months, Intel has lost nearly a quarter of its value while the NASDAQ gained 5.5%. On the flip side, AMD has lost more than half (57.5%) of its value. Where does Intel stand today? And do its multiples still make it a value play? In this article, I try to answer those questions and provide another stock that can hedge against any downside from Intel.

Is Intel (NASDAQ: INTC) Out?

There have been some considerable fears looming that Apple (NASDAQ: AAPL) will abandon Intel. In my view, the consumer electronics producer will do just that for several reasons. First, it has the ARM instruction set license and therefore does not need to go to Intel's "Atom" products even though Atom Z2460 has been able to beat Apple's dual-core A6 processor on some measures. Second, it now has resources in place to produce its own specialized chip, which is a main selling point over competing products. In the end, this cuts Intel off from what would have been a huge secular tailwind.  For example, around a third of Windows users looking to purchase a computer say they want to switch over to Apple.

A decline in PC sales alongside excess inventories has created a bit of a perfect storm for Intel. OEMs are trying to liquidate inventories and chip-makers are now forecasting for a 10% m-o-m December sales decline. Intel is still looking to deliver 14 chips to Haswell desktop CPUs and capitalize on AMD's struggles. But the launch of S1200 Atom servers is fundamentally challenged by a new web-tier landscape that calls for more cores. Declining average selling prices will erode margins, but bear in the mind that the company is taking steps to address this issue. For example, the 2014 launch of Broadwell CPUs will prevent motherboard manufacturers from swapping them from a board and thus will help lower assembly costs for OEMs. More generally, this strategy reflects a desire to improve control over the motherboard market.

Despite some of the above-mentioned headwinds, I find the company overly cheap. It trades at only 9.2x past earnings and a PEG ratio of 0.84x. EPS grew 22.8% annually over the past five years, and it is expected to grow by 10.9% over the next five years. When you factor in the 4.3% dividend yield, reward outweighs risk.

Go Mobile with Qualcomm (NASDAQ: QCOM)

For the greatest upside, Qualcomm is an obvious choice. As a chip-maker targeting the smartphone market, its upside has, however, been strongly communicated to the market, and this is reflected in the 13.3x forward earnings multiple. No matter, 36 of 40 reporting analysts rate the stock a "buy" or better, and only one says it's a "sell." With a 19.6% return on invested capital, which is 756 bps greater than the market consensus, it's easy to see why the Street is bullish.

There are several factors to consider looking at before buying Qualcomm. Merrill Lynch expects the firm to appreciate substantially through greater 4G coverage. Right now, Verizon has more 4G coverage than all of the other carriers combined. More innovation and smaller-scale spectrum takeovers from AT&T and Sprint could shift the market over to a 4G world quicker than expected. While Qualcomm has also stayed ahead of the curve in terms of innovation, its R&D investments have been unable to improve profitability. Over the last five years, R&D expenses grew 106.1% while free cash flow only grew 43.8% to $3.9 billion. This means only $0.41 in free cash flow was gained for every $1 in R&D more invested. But, you need to always consider this relative to the counterfactual: How would Qualcomm have done if it took a different course? One way to gauge this is to look at how successful competitors were with R&D. Intel grew R&D 70.8% but free cash flow barely budged with a 6.5% gain. That's a return of 9 cents on every $1 more invested, or 4.6x less than Qualcomm's return. TI has seen R&D investments decline, but FCF declined even more at 27.4% over the last five years.

It should not be surprising then that Qualcomm is forecasted for a 15.0% annual EPS growth rate over the next five years, which is well above the telecom's 0.7% average. Further, the 19%+ return on invested capital ensures that the company is not recklessly growing but rather creating value in the process. In light of its strong exposure to 4G tailwinds, better handling of R&D, and investor focus on upside, I encourage buying during this uncertain economic period.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Intel, and Qualcomm. Motley Fool newsletter services recommend Apple and Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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