Buy This Stock With Caution

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

Intel (NASDAQ: INTC)is now selling for an almost unheard of valuation with the market basically pricing negative growth for several years into the indefinite future. While it is true that Hewlett-Packard (NYSE: HPQ) and Dell (NASDAQ: DELL) may deserve such a valuation, I will argue that Intel is different in some key aspects, and that it can survive the transition from PCs to mobile and cloud computing better than the rest of the old guard, Microsoft (NASDAQ: MSFT) included in that statement.

First, here are the reasons that Mr. Market thinks that Intel is utterly doomed and thus should be selling for the ridiculous PE of 8.5 with a PEG ratio of 0.7. Compare that to the S&P 500 selling at a PE of 14.5-15.5 for the same metrics.

1. Downward suprises from Dell and HPQ indicate that the launch of Windows 8 has been less than well received so far.

2. CEO Paul Otellini is retiring soon. (Can you say "rats and sinking ship?" Or is it a hidden opportunity to obtain someone more familiar with mobile?)

3. Fears that the fiscal cliff will drive the U. S. as a whole will go into recession again, thus precipitating massive layoffs and another downward spiral in the economy. Companies woud stop upgrading computer equipment, thus hurting Intel's bottom line.

4. Intel hasn't succeeded in entering the mobile space with very low penetration in the tablet space. ARM Holdings (NASDAQ: ARMH) is their main competitor with the most market share and the lead in mobile (thus reflected by ARM's PE ratio of 67).

5. There are umors that Apple is replacing Intel chips with its own design using ARM architecture (think quad core A7x?).

6. Berkshire Hathaway dumped the stock. (Nice move in the short term, Mr Buffett). 

So what makes Intel a legitimate value play and not just a value trap?

1. Intel has some good growth in servers for cloud computing, and this part of the business should grow up enough to compensate for poor PC sales. All of those tablets need apps and those apps need server farms running things in the cloud. Intel makes the microchips powering those servers and the very slick solid state drives (SSDs) that power the cloud.

2. Intel management is acutely aware of their failings in the mobile space, and according to their last earnings conference call, they are working hard to reduce their power requirements and form factor for this space. Just remember that for the longest time Apple used Motorola and IBM Power PC chips for their computers, but Intel by sheer brute force made incremental improvements to win Apple's business. Apple hates giving business to Samsung, and there are not too many companies with the scale to provide the massive number of components that Apple demands. Intel has proven it can win Apple's business and is working hard to gain ground in the space. The gamble will be whether or not it can transition to mobile soon enough before the cash flow coming from legacy PC sales dries up.

3. It has a juicy 4.65% dividend with consistent dividend growth.

4. The fiscal cliff is a red herring. There's no way a bunch of politicians who face election in 2 short years will let themselves be blamed for a recession. This is a game of chicken, and to be honest, the Republican House has a weak hand right now after November's election. The President doesn't have to face the voters again so he has much less to lose. 

5. Really, a PE of 8.5? Intel is one of the premier US tech companies with a top notch R&D team, selling at a PE less than GE (16 or so) or PEP (18 or so), just to name some mature companies in my portfolio. The point is that managment sees the contraction and will adjust capacity accordingly, thus protecting their profits and their cash flow for dividends. They still have excellent net margins and a decent balance sheet with more than $5 billion coming in, and about $1 billion in dividends paid and roughly $10 billion in cash. Price to cash flow is a ridiculously low 6.4! 

6. Intel may be tied to Microsoft, but while Windows 8 and the Surface tablet may help Intel, Intel's fate is in its own hands by pursuing its own deals to embed itself in Android phones, tablets and other devices. Intel has been pioneering 3D circuitry that will help with miniaturization and help with the power consumption problem. As yields improve in the newer designs, the fortunes of the company should improve.

I think there is very little risk of downside below $18 a share and I will continue to accumulate shares with caution. For people seeking some insurance, covered calls and naked puts may help ease the pain. My time horizon is very long and I think that as soon as the economy shows signs of renewed life Intel will richly reward those patient enough to hold on for dear life.

Stock moves happen quickly and missing a week in the stock market can wipe out a year's gain easily if you pick the wrong days to be out of a company. Right now Graham is right: Intel is not popular and its stock price reflects that, but in the end profits matter and the company will live or die by what comes about in the next few years. If it can capitalize on mobile and cloud computing I see a 30-100% upside from these levels. If management proves to be inneffective, then the stock could be dead money for 10 years (albeit earning a nice dividend yield).  Intel is a true Dog of the Dow awaiting its turnaround story.

Fool blogger Erick M. Santos, M.D., Ph.D. (xerohype) owns shares of INTC, AAPL, GE, PEP, ARMH and RAX. The Motley Fool owns shares of Intel and Microsoft. Motley Fool newsletter services recommend ARM Holdings, Dell, Intel, and Microsoft. 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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