Intel's Biggest Problem Isn't the Next Quarter

It's what can the chipmaker do long-term to maintain its historic growth rates now that the PC Age is passing?

By Sam Jaffe

When Intel (INTC ) executives held a conference call for analysts on June 7, it was their last chance before the company's earnings report to warn Wall Street that it wouldn't meet earnings and revenue targets for the second quarter, which closes at the end of June. But the only warning they gave was that revenue would be "on the low end" of the $6.2 billion to $6.8 billion range they had previously given.

Since then, the stock has fallen about 10%, closing June 19 at $26.65. That's bad, but not as bad as other tech stocks that got sucker-punched after coming out with negative earnings preannouncements over the past few weeks.

Intel isn't out of the woods, however. Its stock is still 62% off its 52-week high, and even if it does come in with the $6.2 billion in revenues and 11 cents earnings per share that analysts expect, that's still 25% less revenue and 78% less profit than 2000's second quarter.


  That decline isn't due to anything company-specific but to technology buyers slamming on the brakes en masse when the economy's traffic snarl came into sight. This year, personal computer sales are expected to decline for the first time in the PC's history.

They'll start climbing again at some point, but you can't find anyone preaching that the industry will return to the 30% annual growth of yesteryear. It's just too hard to convince a corporate buyer to invest in new machines every three years when five-year-old machines are still up to the tasks set before them. That's the fundamental problem Intel faces -- the end of the PC craze. It's casting about for other ways to renew growth, but so far it hasn't impressed many investors.

It's trying to boost the use of flash memory so that it can make and sell more such chips, but that's still a tiny market compared to PC processors. Intel also has a grand plan to get into the communications and networking chip business, but that hasn't been a hit with many analysts.


  "The biggest concern is where is the growth going to come from now that the PC market is slowing," says Josephthal & Co. analyst Lawrence Borgman, who has a buy rating on the stock. "The communications and networking idea is vague, and so far that strategy hasn't produced any profits." Without a stronger long-term strategy in place, this stock probably isn't going anywhere.

Intel's short-term problems are pretty much the same as for every other technology company. The spate of corporate tech spending that marked 1999 and 2000 has stopped as companies assimilate their new equipment. Of course, the computer industry has seen plenty of downturns in the past, and this one, although by far the most severe, isn't so different. "The only way to survive a recession is to emerge from it with products better than your competitors," says Intel CEO Craig Barrett.

That means spending lots of money during the downturn, which Intel is ready to do. It has set aside $7.5 billion this year for plant upgrades alone. Interestingly, very little of the money has been earmarked for new-plant construction. "They've said they'll focus on improving productivity and bringing in new technologies," says ABN Amro analyst Paul Leming, who has a neutral rating on the stock. "If they were to build a new plant now, that would signal that they expect a big upturn in demand in 2002 and 2003. That's clearly not in the cards."


  Even if Intel spends all that money preparing for an industry recovery, it still has to contend with a big increase in competition, which is causing major headaches at Santa Clara headquarters. Just three years ago, you could have labeled Intel as a monopoly power in PC processor chips and no one would have argued. But during that time, perennial underdog AMD (AMD ) refused to go away. Thanks to quicker rollouts of new chips, AMD and its new Athlon line stole the performance crown from Intel.

Although most of AMD's chips compete on the low end, the company has been stealing enough share from Intel to make analysts sweat. AMD expects to have 30% of the overall market in PC processors this year, up from as little as 10% two years ago. Just as worrisome for Intel is that AMD is entering one of the most profitable areas of the PC market: laptops. Its new Athlon 4 chip will compete head-to-head with the Pentium 4 in new laptops, a segment with a much higher profit margin than desktops.

"This is the first time that AMD has [emerged as] a significant contender in the laptop market," says John Geraghty, an analyst with Gerard Klauer Mattison. "It shows that for the first time in a long time, Intel has a real competitor." Nevertheless, he rates Intel a strong buy.


  Despite AMD's laptop foray, Intel is banking on the success of its Pentium 4 chip, a major new design that will allow it to regain the performance edge it traditionally has held over AMD. The Athlon has a maximum speed of 1.7 gigahertz, while the Pentium 4 will eventually be able to cross the 2-gHz threshold. In addition, the P4 is optimized for use with new memory-chip designs that will allow it to vastly increase the actual working speed of its computers.

So far, Intel says Pentium 4 sales, which began in February, are on track. "It's by far the most important chip they've introduced in years," says Josephthal's Borgman. "It's hard to forecast sales because it's coming out during a downturn in PC sales, so we won't know for sure if it's a hit until the end of the year." Intel didn't return phone calls seeking comment on future earnings growth.

Regardless, Intel's biggest problem is to come up with a growth engine for the next 5 to 10 years. Powerful new PC processors alone won't do the trick. Even if Intel can retain the title of PC king, the crown may begin to look tarnished without a plan to boost long-term growth.

Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

Questions or comments? Please visit our Ask Sam Jaffe interactive forum

Edited by Beth Belton

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