The Anderson School at UCLA January 2003
This note originally was prepared by Jonathan Bailly, MBA 2003, under the guidance of Professor Pedro Santa-Clara, both from the Anderson School at UCLA, as the basis for class instruction rather than to demonstrate either an effective or ineffective handling of a managerial situation. This case draws heavily from the working paper “Valuing Intel: A Strange Tale of Analysts and Announcements,” by Brad Cornell (UCLA, 2000).
Copyright © 2003 by Jonathan A. Bailly and Pedro Santa-Clara. No part of this publication shall be reproduced, stored or distributed without the prior written consent of the authors. These terms are enforceable under United States (17 USC 101, 35 seq.) and international copyright laws.
Valuing Intel Corporation, Inc.
Introduction
Late in September 2000, Wall Street witnessed an unprecedented event. Over the three-day trading window between Thursday, September 21 and Tuesday, September 25, Intel Corporation’s share price fell 30% and erased over $120 billion worth of shareholder value. The stock failed to recover any substantial amount of this loss during the following months, and the event still ranks as the greatest and quickest evaporation of market value for any individual, publicly-traded company in the history of the stock market.
The Company
In 1968 three engineers in Mountain View, California founded Intel Corporation, Inc. to develop silicon-based computer chips. The company initially provided computer memory chips such as DRAMs and EPROMs, and the success of these products in the 1970s funded microprocessor designs that eventually revolutionized the electronics industry. When Intel's “8088” chip was chosen for IBM's PC in 1981, Intel secured its place as the microcomputer standard-setter.
The company became by far the world’s top semiconductor maker, and even though archrivals such as AMD had eaten into Intel’s market share during the 1990s, Intel still earned several times as much from chips as did any of its competitors. By the late 1990s Intel’s best-known microprocessors, Pentium and Celeron, were installed in about four-fifths of all new PCs, and the company’s flash memory chips and embedded semiconductors for communications and industrial equipment makers commanded top shares of their markets. Coincidentally, during the tech boom Intel realized strong returns from its venture finance wing, Intel Capital, which invested heavily in cutting-edge high-tech companies.
The Stock Market in 2000
The stock market had exhibited one of the loftiest (and, as some argued, irrational) run-ups in history. By the late 1990s movements in even the broader market indexes, such as the S&P 500 and the NASDAQ Composite, became dominated by a handful of brand name, “mega-cap” stocks—typically those of companies in the technology sector. Intel was among the most widely held and heavily traded names on the NASDAQ exchange. Institutional investors held over half of its 6,710,000 shares outstanding. The company’s stock was extremely liquid, with over 30 million shares routinely changing hands in the course of a business day. At certain points in the year Intel held the title of the largest company by stock market capitalization on the NASDAQ, a distinction in league with other heavyweights such as Microsoft, General Electric and Cisco Systems. Size comparisons for these companies during the year are presented in Exhibit 1.
Although valuations for technology companies had plunged from previously celestial heights, by the third quarter of 2000 Intel was the only technology company in the world with a market value exceeding $500 billion. Dozens of celebrity analysts at major brokerage houses, and possibly hundreds more at money management firms, scrutinized Intel’s pronouncements as meticulously as they parsed the syntax of Federal Reserve Chairman Alan Greenspan. Intel was indeed the darling of Wall Street: at the end of August Bloomberg’s index of analyst recommendations for the stock stood at a rating of 4.85 out of a possible 5.0, versus an average of 4.24 for S&P 500 companies. If there ever were a stock to which the semi-strong version of the efficient markets hypothesis should apply, it would be Intel.
2 The Announcement
Just after the close of NASDAQ trading on Thursday, September 21, 2000, Intel Corporation issued a press release (Exhibit 2) regarding its expected financial results for the third quarter. The crucial statement in the release related to the company’s expectations of future revenues:
The company expects revenue for the third quarter of 2000 to be approximately 3 to 5 percent higher than second quarter revenue of $8.3 billion.
Other than this statement, what was most remarkable about Intel’s press release was the absence of anything remarkable. The press release did not mention any changes in the company’s business outlook, possibly including any actions by competitors, any problems with product quality, any changes in technology, any lawsuits or regulatory changes, etc.
In after-hours trading on Thursday night Intel’s stock price plummeted over 20%, from $61.50 to $48.25. When trading resumed on Friday Intel broke the NASDAQ daily trading volume record by over 100 million shares, as 309 million shares of the company changed hands as the stock’s price continued to drop. Exhibit 3 displays Intel’s share price and daily volume for the year.
The market’s reaction on September 20 was all the more puzzling since it is conceivable that the information in the press release might have been partially anticipated by the market. In fact, Piper Jaffray analyst Ashok Kumar downgraded Intel’s stock on September 5 citing lower earnings growth expectations. At the time of the press release, Intel’s price was already down more than 15% from its August 31 high.
Intel executives were perplexed by the dramatic sell-off. A senior executive, in private conversation, expressed amazement at what he considered a relatively minor announcement leading to the destruction of more than one hundreds billions of dollars in shareholder wealth. The announcement, in his view, reflected purely short-run developments in Intel’s European operations, particularly the recent decline of the euro/dollar exchange rate. This was expected to temporarily depress demand for Intel’s products in Europe. However, the news did not indicate any change in Intel’s long-run business strategy, its products, its competitive position, or even—in the executive’s opinion—the long-run demand for Intel’s products. In his view, the market was reacting irrationally to a small amount of bad news. Weeks later, when the stock still had not recovered its lost value, Intel’s chairman, Craig Barrett, succinctly summarized his assessment of the situation by saying, “I don’t know what you call it but an overreaction… that’s feeding on itself.”
Valuation
The huge reaction of Intel’s stock price to what was ostensibly minimal information raises an even more fundamental question than that of overreaction. Since the amount of valuation information contained in the September 21 announcement was small but the market reaction was very large, it seems plausible that the stock may not have been rationally priced by the market. (An often cited example of this dilemma is the stock market crash of October 19, 1987, when the overall market dropped more than 20% on what appeared to be minor news.) Intel’s company spokesman clearly believed in the overreaction story, arguing that the information in the press release was not sufficient to explain the decline. However, the problem with this reasoning is that there is no unambiguous way to quantify the amount of information in the announcement without observing stock price movements in response to the announcement.
This does not mean, however, that the market overreacted in the sense of unrealistically depressing Intel’s stock price. It is entirely possible that the stock was mispriced prior to the press release. This conjecture is supported by the incessant, pro-cyclical nature of analysts’ recommendations. At the end of August, when the stock price was near $75, Intel was one of the most highly touted names on Wall Street. After September 21, 2000, hardly any analyst recommended Intel. One may surmise that historical price performance itself plays a critical role in influencing analyst recommendations.
A discounted cash flow (DCF) model of the stock may help better understand the market’s reaction to Intel’s announcement. Such a model could be calibrated to Intel’s stock price on September 21, just prior to the announcement. The model could then be used to assess the magnitude of changes in the forecasted cash flows that would produce the change in stock price observed in practice. Given the circumstances, the goal of any valuation of Intel should not be to estimate the “true” value of the company either before or after the announcement. No student of finance has access to the kind of information necessary for such unusually accurate cash flow projections. Nonetheless,
by fine-tuning an equity valuation model with announcement cash flow projections, based largely on pre-announcement analyst reports, it is possible to calculate how much the market’s forecast might have changed in order to explain the dramatic movement in Intel’s stock price.
In performing such an analysis, it is assumed that Intel’s cost of capital did not change as a result of the press release. This assumption is strongly supported by empirical data. First, Treasury bond yields did not shift upward as a result of Intel’s announcement. Second, the minor drop in the S&P 500 at the time shows that the equity risk premium was not altered significantly by Intel’s statements. These two facts, in turn, mean that any change in the discount rate would have been caused by a change in the systematic risk of Intel. However, there is no compelling reason to assume that Intel’s beta would have risen or fallen in response to a single announcement, so it is probably best to leave this assumption unchanged. Therefore, the dramatic movement in Intel’s stock price must be explained primarily by changes in the market’s cash flow forecasts for the company. Exhibit 4 contains key operating and financial details for Intel prior to 2000.
DCF models typicall employ the weighted average cost of capital (WACC) to discount cashflows. Because Intel has almost no debt, there is virtually no difference between the WACC and the cost of equity. Even at Intel’s lowest stock market value in the year preceding September 21st, debt represented less than 1% of the company’s
enterprise value. Thus, for simplicity, one can proceed with a valuation analysis as if the company were all-equity financed.
Conclusion
The stock market responded severely to a September 21, 2000 press release in which Intel announced that its revenue growth for the third quarter would be lower than previously expected. By examining the press release in conjunction with analyst reports both before and after the announcement, and by employing a DCF valuation model, one must decide whether or not the press release contained sufficient information about Intel’s long-run business outlook to justify the stock’s drop in response to the announcement.
A difficult task for investors is assessing the long-run implications of new information for a company’s business. For instance, how did the Intel press release affect the company’s long-run revenue growth stream and, consequently, its equity value? Huge price movements on relatively minor information imply that Intel could not have been efficiently priced before and/or after the announcement. This has important implications for financial managers. By failing to focus on fundamental drivers of value and not presenting them explicitly in valuation models, investors run the risk of following naive investment rationales into financial oblivion.
4 Exhibit 1
Market Capitalization for Select Companies in 2000 (Billions of dollars) $150 $250 $350 $450 $550 $650 $750
Jan Apr Jul Oct
Intel Corp. General Electric
Exhibit 2
Intel Third Quarter Revenue To Be Below Expectations
Demand in Europe weaker than expected
SANTA CLARA, Calif., Sept. 21, 2000 -- Intel's third quarter revenue is anticipated to be below the company's previous expectations, primarily due to weaker demand in Europe, the company said today. The company now expects revenue for the third quarter to be approximately 3 to 5 percent higher than second quarter revenue of $8.3 billion.
The company expects gross margin percentage for the third quarter to be 62 percent, plus or minus a point, lower than the company's previous expectations of approximately 63 to 64 percent. Interest and other is expected to be approximately $900 million for the third quarter, up from the company's previous expectations of $800 million.
BUSINESS OUTLOOK
The following statements are based on current expectations. These statements are forward-looking, and actual results may differ materially. These statements do not reflect the potential impact of any mergers or acquisitions that may be completed after the date of this release.
** The company expects revenue for the third quarter of 2000 to be approximately 3 to 5 percent higher than second quarter revenue of $8.3 billion.
** The company expects gross margin percentage for the third quarter to be 62 percent, plus or minus a point. Gross margin percentage for 2000 is expected to be 63 percent, plus or minus a few points. In the short term, Intel's gross margin percentage varies primarily with revenue levels and product mix as well as changes in unit costs.
** Expenses (R&D, excluding in-process R&D, plus MG&A) in the third quarter of 2000 are expected to be up 7 to 9 percent from second quarter expenses of $2.2 billion, primarily due to higher spending on marketing programs and R&D initiatives in new business areas. Expenses are dependent in part on the level of revenue.
** R&D spending, excluding in-process R&D, is expected to be approximately $4.0 billion for 2000. ** The company expects interest and other income for the third quarter of 2000 to be approximately $900 million. Interest and other is dependent in part on interest rates, cash balances, equity market levels and volatility, the realization of expected gains on investments, including gains on investments acquired by third parties, and assuming no unanticipated items.
** The tax rate for 2000 is expected to be approximately 31.8 percent, excluding the impact of the previously announced agreement with the Internal Revenue Service and acquisition-related costs. ** Capital spending for 2000 is expected to be approximately $6.0 billion.
** Depreciation is expected to be approximately $790 million in the third quarter and $3.4 billion for the full year 2000.
** Amortization of goodwill and other acquisition-related intangibles is expected to be approximately $400 million in the third quarter and $1.5 billion for the full year 2000.
Copies of this earnings release and Intel's annual report can be obtained via the Internet at www.intc.com or by calling Intel's transfer agent, Computershare Investor Services, L.L.C. (formerly named Harris Trust and Savings Bank), at (800) 298-0146.
Intel, the world's largest chip maker, is also a leading manufacturer of computer, networking and communications products. Additional information about Intel is available at www.intel.com/pressroom.
6 Exhibit 3
Intel Trading History, 2000
$0 $10 $20 $30 $40 $50 $60 $70 $80
Jan Apr Jul Oct
St oc k P ri ce 0m 50m 100m 150m 200m 250m 300m 350m Tr ad in g V ol u m e
Exhibit 4
Selected historical financial data for Intel Year ended December 31,
Millions of dollars 1995 1996 1997 1998 1999
Net revenues $ 16,202 $ 20,847 $ 25,070 $ 26,273 $ 29,389 Cost of sales 7,811 9,614 9,945 12,088 11,836 Research & development 1,296 1,808 2,347 2,509 4,264 SG&A 1,843 2,322 2,891 3,076 3,872 Income from operations $ 5,252 $ 7,103 $ 9,887 $ 8,600 $ 9,417
Marginal tax rate 33% 33% 33% 33% 33%
Tax on operating income 1,733 2,344 3,263 2,838 3,108 Net Operating Profit After Tax $ 3,519 $ 4,759 $ 6,624 $ 5,762 $ 6,309 Depreciation 1,371 1,888 2,192 2,807 3,186 Increase in working capital 1,700 (200) (320) 40 (380) Capital expenditures 3,550 3,024 4,501 3,557 3,403 Cash flow from operations $ (360) $ 3,823 $ 4,635 $ 4,972 $ 6,472
Percentage of Sales 1995 1996 1997 1998 1999
Net revenues 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of sales 48.2% 46.1% 39.7% 46.0% 40.3%
Gross Margin 51.8% 53.9% 60.3% 54.0% 59.7%
Research & development 8.0% 8.7% 9.4% 9.5% 14.5%
SG&A 11.4% 11.1% 11.5% 11.7% 13.2%
Income from operations 32.4% 34.1% 39.4% 32.7% 32.0%
NOPAT 21.7% 22.8% 26.4% 21.9% 21.5%
Depreciation 8.5% 9.1% 8.7% 10.7% 10.8%
Increase in working capital 10.5% -1.0% -1.3% 0.2% -1.3%
Capital expenditures 21.9% 14.5% 18.0% 13.5% 11.6%
Cash flow from operations -2.2% 18.3% 18.5% 18.9% 22.0%
Growth Rates 1996 1997 1998 1999
Net revenues 29% 20% 5% 12%
Cost of sales 23% 3% 22% -2%
Research & development 40% 30% 7% 70%
SG&A 26% 25% 6% 26%
Income from operations 35% 39% -13% 10%
NOPAT 35% 39% -13% 10%
Depreciation 38% 16% 28% 14%
Increase in working capital -112% 60% -113% -1050%
