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William Schaff
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Taking Stock: Wall Street Takes A Critical Look At Intel

How to best determine the value of Intel: peak or core earnings?

How quickly sentiment changes on Wall Street. A short while ago, the Street was forecasting that the upturn in the economic cycle should result in strong trends for tech stocks. Now, all I'm hearing is that mid-2005 is going to be the peak of this technology cycle and that tech stocks should be sold now in anticipation of that peak. Even Intel, the leading microprocessor company, isn't immune to these sentiment shifts, as its stock price has dropped from a recent peak of $34 to $24 after its earnings call. Is this rational?

First, let's look at company fundamentals. Intel, during its recent earnings call, reported that quarterly revenue grew 18% and earnings per share rose to 27 cents from 14 cents last year, in line with expectations. Despite the good news, Intel also disclosed an inventory buildup and lowered its gross-margin forecast--very significant points for a company the size of Intel.

Now let's look at why Wall Street analysts began downgrading Intel and lowering their price targets. As I see it, analysts continued to use peak economic cycle price targets so that there was little upside if the economic or business outlook changed. And, sure enough, the outlook changed.

Analysts then adjusted their stock-price targets to reflect historic "core" earnings and sales more representative of the average of a full economic cycle period. For example, Intel's price/earnings multiples have usually averaged between 15 to 35 times EPS estimates. Clearly, using 35 may seem too aggressive, just as using 15 may seem overly conservative. The real issue is, what are "core" earnings per share? Do you use Wall Street consensus earnings forecast of $1.44 for 2005? At 35 times EPS estimates, the stock-price target may be as high as $50 or as low as $22, with an average around $36. That would make Intel stock look cheap at $24. Or do you adjust the 2005 EPS to reflect a more rational "average" earnings over a full economic cycle in order to establish a reasonable price target? Let's just say the average earnings are closer to $1.00 instead of $1.44. Now the stock might trade between $35 and $15 with an average value of $25--not the bargain that peak earnings would imply.

In addition, this doesn't adjust earnings for stock-option expensing, which might dilute Intel earnings by another 15%. This would put core earnings closer to 86 cents per share. Now the price range is between $30 and $13, with an average price of $22. So there may be additional downside if options expense is adjusted for in the stock price going forward.

However, investors need to be aware that Intel's stock price also tends to trade within the framework of the overall stock market. If the stock-market multiples decline, Intel's market multiple also should decline. Interestingly, in my experience, Intel has traded based on the EPS multiple, but the share price tends to rise or decline based on the change in the rate of sales growth or the change in gross margin.

Before you say that the market doesn't understand Intel's value, think about my rough numbers. Value is in the eye of the beholder, and it seems the rose-colored glasses just came off.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.

To discuss this column with other readers, please visit William Schaff's forum on the Listening Post.

To find out more about William Schaff, please visit his page on the Listening Post.

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