Intel: Better Than Meets the Eye


By Olga Kharif CEO Craig Barrett clocks hundreds of thousands of airborne miles directing the affairs of Intel (INTC), the world's largest chipmaker, but he's always careful to keep its feet squarely on the ground. Witness the latest earnings announcement on Jan. 14. While fourth-quarter revenues of $7.2 billion were up 10% sequentially, Barrett nevertheless sounded a cautionary note, announcing that Intel will slash capital spending in 2003 by up to 26%. Wall Street took the announcement as a red flag.

Investors, however, may want to look a little closer. Barrett's push to keep expectations down to earth could yield pleasant surprises, if unit sales exceed analysts' expectations.

Since those capital-spending cuts were deeper than expected, Intel's stock dropped from just shy of $18 on the day of Barrett's announcement to $15.85 as Jan. 24's close. The news appeared to be fresh evidence that a recovery in PC sales, which drive 80% of Intel's revenues, will be weaker than had been expected. Shares of semiconductor-equipment makers also tumbled.

BLAZING FINISH? Don't forget, however, that many analysts have long predicted slow growth in demand for chips in 2003 -- and that Intel must cut costs rather than ramp up capacity. In that light, Barrett's moves look like a sound strategic decision. Standard & Poor's recently upgraded the stock from avoid to hold, based on fourth-quarter performance and the capital-spending cuts.

Lower costs -- more than a recovery in demand -- could make Intel's financials shine later this year. Let's look at the fourth quarter, which ended Dec. 31. Intel sold 34 million processors, surpassing its previouls quarterly record of 33 million units in 2000, estimates Jonathan Joseph, an analyst with Salomon Smith Barney. Yet it generated $1 billion less in profits than in its record quarter of 2000.

That's because processor prices have fallen. And Intel's overall costs have increased as a percentage of revenue, partly because it has invested in new chipmaking plants, or fabs. As a result, gross margins now stand at 51.6%, vs. 62.9% two years ago.

THREE OPTIONS. Intel has three ways Intel to restore margins, Joseph figures: The first would be a jump of 25% to 30% in unit sales. Second, prices on processors might rise by the same amount. Third, costs could shrink.

Option No. 1 looks problematical. Chip sales should increase by only 9% this year, according to Salomon Smith Barney. Option No. 2 appears no more likely, since Intel's processor prices have fallen 30% from a high of $235 in 1996, estimates Joseph, who sees that trend continuing.

He has a point: Processor speed, which had been accelerating by between 60% to 70% annually, will increase by only 11% in 2003, Joseph believes, and a typical PC buyer goes for lower price, not faster performance. Plus, Intel's main rival, AMD (AMD), will unveil several new chips this spring, which could further pressure Intel to pare prices further.

READY TO MOVE. That leaves the third option. While Intel has decided to cut capital spending this year, it's actually at the tail end of a three-year increase in capacity. A new fab in Rio Rancho, N.M., that became operational in October should increase overall capacity by 15% this year, estimates George Burns, president of chip-development consultancy Strategic Marketing Associates. If, as expected, demand recovers in 2004, this extra capacity will come in handy. When operating at full tilt, the new plant will offer 30% cost savings over older fabs.

Intel has already built most of its new plants, so it should hold off on equipping them until demand picks up, says Marc FitzGerald, an analyst with Banc of America Securities. Small wonder Intel will spend only $3.5 billion to $3.9 billion on capital improvements this year, vs. $4.7 billion in 2002. Until demand picks up, Intel will save up to $1.2 billion over last year -- a substantial sum for a company that booked $26.8 billion in revenue in 2002.

Intel spokesperson Chuck Malloy says the chipmaker's new plants are on schedule. "When the economic upturn comes," he says, "we'll be in a position to ramp up very, very quickly."

BARGAINING POWER. Additionally, Intel should be able to leverage capital spending further in 2003. Semiconductor gearmakers are desperate for sales, taking a further 10% off the cost of already discounted machines, estimates Fred Wolf, an analyst with investment firm Adams, Harkness & Hill. On some equipment, Intel's sheer size and buying power mean even better deals are likely. Last year, according to S&P, it accounted for nearly 20% of the money spent on semiconductor equipment.

In the past month, Intel closed an older plant in Oregon that made flash memory chips more expensively than its newer plants. Evaluations of the building are under way to see if it can be used for a newer manufacturing process, says Malloy. And as of early January, 2003, Intel quietly exited its ASIC (application specific integrated circuit) custom-chip business. Analysts think the operation was attracting too few customers to justify the outlay. Intel has already stopped accepting new orders, though it will complete the design projects it had already started, says Intel spokesperson Erica Fields.

Intel expects margins to remain steady, at 51%. Most portfolio managers are waiting for substantial increases in demand -- and bottom-line boosts -- before picking up Intel again. Howard Sutton of the $300 million Tera Capital Global Fund, is shorting the stock. He believes it will drop to the low- to mid-teens and says more cuts may be needed before values begin to rise again.

LOW-BALL ESTIMATE? It likely will be years, if ever, before Intel revisits the sort of stellar financial performance that marked 2000. But with $1 billion in profits in its latest quarter, it remains squarely in the black. Plus, it has $10.8 billion in cash and short-term investments on hand.

Barrett seems to be counting on Salomon Smith Barney's projections for chip demand in 2003 being too low. And any further rises in unit sales later in the year will be gravy on an improving financial picture. All told, if it catches just a few breaks, Intel could provide investors with a fairly pleasant surprise. Kharif covers technology for BusinessWeek Online


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