Don't Count Intel Out Just Yet

Over the past decade-plus, Intel's INTC prowess in chip design and manufacturing has enabled it to dominate the PC and server processor markets. Yet in recent years, computing power has bifurcated around the PC, as smartphone adoption has coincided with the rise of cloud computing. Although it missed the boat in smartphone processors, Intel's near monopoly in server central processing units, or CPUs, has allowed the wide-moat chip titan to enjoy stellar profitability amid a declining PC market while riding the cloud wave to substantial growth in its data center group.

However, Intel appears to have a worthy challenger in server CPUs with Advanced Micro Devices AMD and its Epyc offering. Although AMD has minimal share today, the combination of Intel's 10-nanometer process technology delays and AMD's upcoming 7-nm Epyc 2 has led the market to anticipate substantial share gains for AMD and the demise of Intel. We strongly disagree with this sentiment and see a compelling opportunity in shares of Intel, while shares of AMD look overvalued.

We concede that 2019 will be strenuous for Intel because of macro weakness, U.S.-China tensions, and share loss, but overall revenue growth should eventually stabilize. As Intel gets back on track in 2020 with its 10-nm Ice Lake server parts, we think its data center group, or DCG, will enjoy average top-line growth of 10% through 2023. AMD's Epyc 2 chips will ramp in the third quarter, and we think the firm will approach 10% server CPU unit share by the end of the year. Beyond 2019, we expect more modest share gains for AMD, as we think intensified competition will bring out the best in Intel.

Intel's Wide Moat Can Withstand AMD's Advances The x86 ecosystem (in which Intel's and AMD's core products coexist), contains the vast majority of PC and server chips. Network effects have played a big role in its dominance, as proprietary computer software has been written specifically for the x86 architecture, leading to significant switching costs. The growth in the PC market allowed Intel to invest heavily in research and development to fuel continued progress in the x86 architecture and software developer network.

In recent years, though, the PC market has stagnated with the rise of tablets and smartphones, which run on processors based primarily on lower-power ARM architecture. Although ARM still has a commanding lead in mobile devices and PC sales are declining, x86 has flourished in server processors. Intel's processors are in the lion's share of servers, and we believe the x86 ecosystem coupled with the newer server CPU variants developed with 10-nm technology will continue to thwart offerings by ARM.

As a fellow x86 chip supplier, AMD is a bigger threat to Intel in the server CPU market. AMD is vying to be more competitive in the server space, with 7-nm products to be launched in the third quarter of 2019. Operating off of a low share base, AMD should be able to gain some traction in the data center in the coming years. However, between aggressive pricing and 10-nm Ice Lake server CPUs slated for early 2020, we expect Intel to defend its dominant position in the server market. We believe the market is overweighting AMD's long-term prospects, providing investors with a buying opportunity in wide-moat Intel.

Semiconductor manufacturing is inherently capital-intensive, requiring methodical planning and execution to keep the cost per chip reasonable. Intel accomplishes this by investing in the latest process technologies. However, for the economics of the business to be pragmatic, there needs to be strong demand via differentiated products that can be sold at high margins and sufficient volumes, which Intel achieves with its massive R&D budget that averaged $13 billion annually from 2016 to 2018, well ahead of most peers.

Intel's wide moat comes from the superior cost advantages in its design and manufacturing of cutting-edge microprocessors. Though its latest 10-nanometer process technology has been delayed, Intel's scale remains considerable. Between its x86 dominance in PC and server CPUs (85%-plus market share in aggregate, according to Mercury Research) and aggressive focus on new chip opportunities (artificial intelligence, automotive, 5G, and so on) we think Intel is likely to earn excess returns on invested capital over the next 20 years. In contrast, we do not believe AMD possesses an economic moat.

Intel INTC Our fair value estimate for Intel is $65 per share and implies an adjusted P/E ratio of 15 times. As the PC market continues to decline, we see server processors supplanting sales in PC processors, ultimately leading to overall revenue growth in the midsingle digits through 2023.

In the near term, we see Intel's PC-derived revenue declining in the low single digits. However, the proliferation of cloud computing and burgeoning Big Data and artificial intelligence trends will provide tailwinds for the data center group, which we see growing at a 7% compound annual rate through 2023.

Beyond our explicit five-year horizon, we foresee the automotive segment spearheading revenue growth. Mobileye's incumbency in countless advanced driver-assistance systems and robust pipeline of design wins, coupled with Intel's technological and financial resources give us confidence Intel will be a formidable player in the race to self-driving cars. We estimate a $3.7 billion opportunity for Intel by 2025 in this industry.

Advanced Micro Devices AMD AMD's fair value estimate is $19 per share, which implies an adjusted forward price/earnings ratio of 28 times. We expect the firm to achieve a top-line CAGR of about 12% through 2023. The firm's computing and graphics segment has enjoyed a resurgence in recent quarters with new products to combat offerings from Intel and Nvidia, with solid initial traction. AMD's target markets had been under heavy duress in recent years, though, as Nvidia NVDA and Intel, respectively, have typically had more success. That said, AMD's recent GPUs, tailored to mainstream gamers, have been recapturing modest share from Nvidia, while also benefiting from cryptocurrency-related GPU demand in 2018.

However, near-term volatility in cryptocurrency prices has likely ended the tailwinds AMD has enjoyed from miners using its GPUs, and we anticipate graphics revenue to be down in 2019. While potential share fluctuations will have disproportionate effects on AMD and Nvidia (with AMD benefiting considerably more than Nvidia hurting), the financial windfall is vital for AMD to stabilize its business.

Its Zen-based Ryzen PC processors should also bolster financial results, as it looks to bring more competitive offerings to the market to challenge Intel.