Intel Fights Back as Chips Are Down

The world's largest chipmaker is under pressure from rival Advanced Micro Devices, weak demand, and falling profits

It says something about the state of the semiconductor business when the world's largest chipmaker reports a quarter in which it sold more microprocessors than ever before but still sees its profits fall 39% from a year ago.

That's the position that Intel (INTC) finds itself in, but the results certainly could have been worse. Reporting sales of $9.7 billion for the fourth quarter, Intel hit the high end of the range it had previously forecast and beat consensus estimates of $9.44 billion. Profits came in at $1.5 billion, or 26¢ per share, beating the average expectation of Wall Street analysts by a penny a share.

The results capped a year where Intel has changed much about itself. At the beginning of 2006, it launched a major revision of its branding strategy, dropping its long-known Pentium name in favor of a new and somewhat confusing brand name, Core. Intel has also been cutting jobs, having finished the year with about 8,400 fewer employees than the 102,500 it started the year with, a move it says will help save $2 billion in operating expenses this year and $3 billion per year by the end of 2008.

Margins Under Attack

It was also a year of fighting harder than it has been used to against rival Advanced Micro Devices (AMD), which scored an important victory by securing its first purchase orders from Dell (DELL). The PC giant previously bought its microprocessors only from Intel. As usual, the scrap between the two bitter rivals has devolved into a price war, one that has, again as usual, punished AMD more than Intel. On Jan. 12, AMD warned that sales and profits would come in below expectations, blaming "significantly lower average selling prices." AMD reports its earnings on Jan. 23.

Intel's results included a one-time gain on the sale of the company's wireless and mobile chip division to Marvell Technology (MRVL) for $483 million. The results also included $457 million in one-time charges related to restructuring and asset-impairment charges from the shutdown and sale of a chip factory following the sale to Marvell. Intel's stock dipped to $21.33, down 97¢, or more than 4% in after-hours trading.

But it's clear the pressures on Intel will remain throughout 2007. The company says it expects revenues for the current quarter to come in at $8.7 billion to $9.3 billion, vs. a consensus estimate of $8.93 billion, reflecting in part a typical seasonal dip in demand. But gross margins will remain under attack, coming in at 49% plus or minus two points for the current quarter and 50% for the full-year. Gross margins for the fourth quarter were down 49.6%, from 61.8% a year ago.

"Like Lemmings"?

Any hope for an improvement in pricing will depend on the supply. If demand for servers and PCs doesn't pick up soon—and its not expected to for a few quarters yet—Intel and AMD will find themselves in a market flooded with chips and not enough customers to buy them, further depressing prices.

Intel appears to be holding steady on its production capacity, saying that it plans to spend $5.5 billion in capital expenditures in 2007. "Intel is sitting on about three months' worth of inventory, and so it's modulating its manufacturing capacity relative to weaker demand," says Ashok Kumar, analyst with Raymond James Financial (RJF).

What's unclear are AMD's plans for production capacity. The company has a plant that is under construction in Germany, and it plans to break ground on another plant in upstate New York this summer. The new factory in Germany, Fab 36 in Dresden, was expected to be fully operational by the end of 2006, but the company has not provided a new timetable for production. "When the market is growing at 10% to 12% and AMD says it wants to grow its production at double that rate, the numbers don't add up," Kumar says. "One would hope that AMD would exhibit some production discipline; otherwise they'll both [Intel and AMD] end up like lemmings going off the cliff together."

Trim Inventory

Sales of chips for servers and notebook PCs were strong, while sales into the desktop sector appeared to be lackluster. Analyst Nathan Brookwood, head of research firm Insight 64, says that much of the pricing battles between Intel and AMD occurred in the desktop space, where AMD has a lot of loyalty among technically savvy consumers, including gamers.

"Intel doesn't say much about desktops in its report, and from my perspective I would guess that a lot of that has to do with selling off the last of the old Pentium D- and Pentium 4-type processors," he says. "Inventories have come down a bit. As Intel eliminates a lot of what Paul Otellini has called the 'brown banana' inventory, I think some price stability will probably return."

There is evidence that some of the older chips are finally getting flushed out. Martin Kariithi, an analyst with Technology Business Research, noted that Intel's inventories dropped by $163 million from the third quarter. "This was the first drop in quarter-to-quarter total inventories Intel has witnessed since the second quarter of 2005," he wrote in a research note. The drop, he writes, indicates stronger demand for new Intel products and strong results during the holiday season.