Intel's Thinning Memory Margins

Lagging PC and consumer electronics sales due to the economic slowdown have put pressure on profits from Intel's NAND flash memory chips

It seemed like such a good idea at the time. In late 2005, Intel (INTC) announced a joint venture with Micron Technoloy (MU) to build a type of memory chip known as NAND flash, placing a big bet on a technology that's widely used in consumer electronics (, 11/22/05). More than two years on, Intel is smarting as prices for those chips tumble.

Intel, the world's largest computer chipmaker, said late on Mar. 3 that it now expects gross margin, a measure of profitability, to be about 54% in the current quarter, cutting an earlier forecast for a gross margin of 56%. The main reason: lower-than-expected prices on NAND flash memory. Intel shares sagged during much of the following day, before staging a late-day recovery to close a penny lower, at 20.

Analysts Point to Bigger Issues

Still, several analysts revisited sales and stock forecasts for the chipmaker, some speculating that falling memory prices are but one of several woes facing Intel as PC demand falters. "Beyond the weaker NAND prices impacting margins, we believe Intel is facing a weaker mix in PC-related sales as the U.S. economy slows," says Edwin Mok at Needham & Co..

The idea that NAND would have so big an impact on Intel's margins came as a surprise to some analysts. Intel is a recent entrant to the market, and NAND flash still accounts for a small slice of overall sales. Intel accounts for a mere 3% of the global market, and ranks fifth behind Micron, Hynix, Toshiba and Samsung, according to researchers at iSuppli.

What's more, NAND flash makes up "only 3% of total Intel revenue, or $300 million per quarter," JPMorgan (JPM) analyst Chris Danely argued in a research note issued after Intel's disclosure. For NAND to be the sole cause of Intel's overall margin squeeze, the gross margin on NAND would have to have plummeted to –47% from 20% in a single quarter, Danely wrote.

A potentially bigger challenge? Danely and other analysts point to rising stockpiles of unsold chips. "Intel's microprocessor business is below expectations from excess microprocessor inventory in the channel," according to Danely. "We believe Intel will need a strong March to achieve the midpoint of its guidance, which will be difficult, given the strong headwinds from high inventory and weakening PC demand."

Chips Take a Hit from Economic Slowdown

As tepid as demand for PCs may be, there's no denying the severity of price pressure on NAND chips, which store data even when the device in which they're being used has been turned off. That makes them ideal for use in consumer products like music players from the likes of Apple (AAPL), and digital camera memory cards from SanDisk (SNDK). An 8-megabit chip that would have sold for $7 a year ago is now selling for less than $3, says iSuppli analyst Nam Kim. After seeing double-digit profit margins from chip sales during 2007, many NAND vendors are likely now seeing operating losses, Kim says.

Since NAND chips are used almost exclusively in consumer products from memory cards to music players to thumb drives and, occasionally, even in PC hard drives, the business is more exposed than any sector of the chip business to consumer sentiment, Kim adds. "Between 85% and 90% of NAND chips end up in the retail market, and that depends on consumer spending," he says. "When people are afraid of a recession, or when they have budget constraints, they don't upgrade the memory card on their camera or [they] forgo buying a new iPod. It's a sector that's very sensitive to the consumers, and their outlook is pressuring the market substantially."

Global sales of NAND chips are likely to grow only slightly in 2008, after rising about 12% to almost $14 billion in 2007, Kim says. Apple is having an outsize impact on the market. The company, which uses NAND flash in the iPhone and all but one version of its iPod player, has reduced its orders for NAND in 2008.

Even as demand slumps, chipmakers are planning ahead for an economic turnaround, adding NAND manufacturing capacity. ISuppli expects capital spending on NAND to grow by 20% in 2008.

Restoring Inventory Balance

Citigroup (C) analyst Glen Yeung thinks the effects on Intel will be short-lived. Prices on the chips are nearing bottom and Yeung predicts that more than one-third of the reduction in expected gross margin may be the result of a onetime writedown on NAND inventory. "While the negative effect of NAND will impair margins throughout 2008, we anticipate a waning impact as the year progresses," he wrote in a Mar. 4 research note.

As the U.S. economy veers toward recession and consumers and businesses alike rein in demand for PCs, Intel will need all the margin support it can get.

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