Why We Think Intel Will Cut Its Dividend (NASDAQ:INTC)

Tough Times

Intel Corporation (NASDAQ:INTC) has had a tough go over these last few years. The once unstoppable American chip giant has been felled by leaner competitors, and the earnings from last quarter showed the world just how far the company had fallen. Year-over-year earnings declined 20%, from $79 billion in 2021 to $63 billion in 2022. Operating income fell by almost 90%, down to $2.3 billion from $22 billion in 2021.

There are plenty of good articles out there that dissect the company’s dismal earnings, so we won’t focus on all the gory details here. Instead, we’d like to focus on the second and third order effects of the earnings results, and do a deeper dive on why we believe Intel will likely be forced to slash its dividend in 2023.

Margins & CAPEX

Before we analyze the company’s cash position and future capital expenditure (CAPEX) obligations, let’s take a quick overview of the health of the business by examining cash flows from 2022.

Intel kicked off $15.4 billion in cash from operations in 2022, compared with $29.4 billion in 2021. Add in $28 billion in capital expenditures, and the company was free cash flow (FCF) negative for the first time in more than 10 years. It goes without saying that this is bad. The question is whether or not investors can expect this trend to continue.

We believe that it will. Intel’s management declined to provide guidance for 2023, leaving investors in the dark as to what the next year might bring. What we can glean from the company’s 10K about future expenses, however, do not paint a pretty picture.

Intel has embarked on a renewed CAPEX cycle over the last few years, and it expects that its CAPEX spending will increase significantly from historical levels. To give you some sense of what non-inflated CAPEX looks like, the average, pre-COVID CAPEX looking back to 2017 was around $13 billion annually.

Don’t take our work that CAPEX will remain elevated. Read what management has to say from the Liquidity and Capital Resources subsection of the 10K:

As we invest in multiple expansions, we expect our capital expenditures to continue to be higher than historical levels for the next several years. We expect to adjust the cadence of our investments based on the execution of our roadmap and changing business conditions. As of December 31, 2022, we had commitments for capital expenditures of $22.7 billion for 2023 and had $8.3 billion in capital expenditures committed in the long term. As of December 31, 2022, other purchase obligations and commitments in 2022 under our binding commitments for purchases of goods and services were $3.1 billion, with an additional $7.6 billion committed in the long term.

So, the company has already committed $31 billion in CAPEX, with $22.7 billion representing the current portion due within 2023.

However, there’s more.

In Note 19 of the 10K, Commitments and Contingencies, the company spells out that it still has a pending $5.4 billion commitment for its acquisition of Tower Semiconductor.

The company has an additional large, unfunded commitment in its much-hyped Arizona fab facility, for which it partnered with Brookfield to build. The joint venture, Arizona Fab, LLC, will cost Intel a total of $29 billion. As of the end of 2022, Intel still had commitments of $13.5 billion remaining in the project. (We went through the deal documents to assess when this payment would be do, but payment schedules were omitted from the filings as is common.)

Intel’s total commitments then for 2023 could be anywhere from $36.4 billion to $49.9 billion, depending on a) the timing of the payments due to the Arizona Fabrication project, and b) the timing of the closing of the Tower Semi deal, if it closes at all.

Giving Yourself A Break

Of course, all of the CAPEX costs will result in enormous depreciation charges on the income statement in future years. Unlike capital-light businesses, we caution investors that they ignore depreciation in capital-intensive businesses (like Intel) at their own peril. As we’ve said before, the CAPEX chickens have to come home to roost sometime, and they do so in the form of depreciation.

To that end, we always keep an eye out for companies that adjust the useful life calculations of their property, plant, and equipment. Elongations of useful life mean that charges will decrease and release pressure on operating margin, while decreases will have the opposite effect. You can imagine that less than scrupulous management teams could utilize this accounting sleight of hand to provide an assist to earnings.

Of course, this is not always the case, and more often than not the extension of useful life of equipment is completely above board. Investors, however, must be on the lookout and understand that if a reduction in depreciation and amortization costs drive the bottom line number higher, it isn’t necessarily an indicator of better operating results at a company.

For example, at the end of 2022 both Google (GOOG, GOOGL) and Amazon (AMZN) extended the life of server equipment in their cloud computing operations by one year. To give you a sense of the impact this one year extension has, for Google the resulting change was a more than $3 billion reduction in annual depreciation charges. For the record, we didn’t do the math here–Google disclosed that amount in its 10K.

So, yeah, these changes matter.

Knowing this, we checked Intel’s accounting estimates, and found that on page 83 of the 10K, Intel did indeed conduct a re-assessment of the useful life “of certain machinery and equipment in our wafer fabrication facilities” by three years, from five to eight. The company stated that this adjustment would reflect beginning in the first quarter of 2023.

Intel did not provide a figure or estimate of the impact that this extension would create. Depreciation charges in 2022 were a little more than $11 billion, however, and this number contributed directly to the squeezing of the company’s operating margin–we expect that in coming quarters this number will deflate significantly. (Of course, it may not go down. Given the large CAPEX for 2023, it may actually go up. But investors should know that within whatever number is presented by the company is a large depreciation reduction on equipment owned by Intel.)

And now, the payoff for all this depreciation talk: investors often conflate net income or earnings per share (EPS) with cash flows, and incorrectly equate the profit on the income statement with a company’s cash position. Indeed, this is one way that investors fall prey to relying on a much-loved metric, the Dividend Income Ratio. Unsuspecting investors can be lulled into a false sense of security when using this ratio, because it analyzes net income from the profit and loss statement rather than actual cash flows.

Investors, then are often caught unaware when companies slash dividends because they have based the safety of the dividend on a profit figure that can be easily adjusted through accounting versus closely examining the ability of the business to generate enough cash to cover it.

A Question Of Cash

In 2022, Intel paid a dividend of $0.36 per share each quarter. This totals out to an annual cash outlay of close to $6 billion per year. At the end of 2022, Intel had a combined cash and short-term investments of a little more than $28 billion, down from $29 billion in 2021.

In 2022 Intel was free cash flow negative to the tune of about $10 billion. Given that management declined to provide yearly guidance, we are left to speculate on what operating cash flow will be in 2023.

If we assume that operating cash flow remains the same or grows a little–let’s say $17 billion–and add in our estimates that Intel’s capital expenditure and acquisition outlay in 2023 will be $40 billion (a midpoint between our two estimates above), we are left to estimate an annual negative free cash flow of $23 billion.

Intel’s current dividend is a yearly obligation of around $6 billion at its current levels. With the amount of spending slated on the books that we’ve already covered, it isn’t hard to see that the Intel may find itself in a bad spot.

Of course, you may have already thought that Intel can raise debt to cover these long-term costs and then pay them off over time. We expect that they will do that to some degree. If an investor decides that this is a safe and sustainable course of action for Intel to take, then that investor should know that they are really making a bet that robbing Peter to pay Paul today will not come back to bite Intel.

But long-term expenditures aren’t the only issue that will demand cash from Intel, as the company’s Accounts Payable ballooned in 2022 from $5.7 billion to $9.5 billion. Much of this will have to be settled with cash.

Turning To Commercial Paper

Disturbingly, Intel turned to commercial paper to raise funds in 2022, which also calls into question its cash position and its ability to continue holding a $6 billion annual dividend obligation on its books.

Commercial paper is very short-term debt, and companies generally use it to bridge financial shortfalls and cover liquidity gaps. It’s often used by financial institutions, for example, to ensure they meet certain liquidity ratios required by regulators.

In 2019 and 2021, Intel brought in no financing via commercial paper, presumably because it had enough liquidity to bridge whatever gap it may have had. In 2022, the company raised $3.9 billion via commercial paper. (The company notes in its 10K that it has authorization from the board to draw on up to $10 billion in funding through commercial paper, but it doesn’t specify when this authorization was granted.)

The company does not disclose why it raised money in this way, or what need it had for it, but investors should know that this is something relatively new for Intel. Given the lack of disclosure around why it is now being utilized, we are left to speculate about Intel’s liquidity position.

The Bottom Line

In sum, we believe that Intel is more than likely to cut its dividend in 2023. The company may stave off a cut temporarily through debt financing, but we believe that this will not be a sustainable solution unless the company executes a fantastic turnaround.

When you add up negative cash flows, high levels of planned capital expenditures, and utilization of short-term liquidity instruments like commercial paper, and a lack of guidance from management, its clear to us that if Intel doesn’t cut the dividend, it is at least the prudent thing for the company to do given the uncertainty surrounding the company.

Investors should also not be lulled into a false sense of security by relying on metrics such as the dividend income ratio, for reasons described above.

For all these reasons, we believe investors should take pause before considering an investment in Intel at this time.

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