Intel Is Developing a New ... Rut

More than halfway into what's supposed to be the "trough" quarter for chips, there are no signs that microprocessor giant Intel (INTC) is going to emerge anytime soon from its current downdraft.

Despite its belief that business will get better, Intel is facing a formidable list of issues this quarter. Smaller competitor Advanced Micro Devices (AMD) is winning contracts from companies that once dealt only with Intel. Intel has cut prices sharply to make sure it doesn't cede any more market share. And a general decline in PC demand has eaten into shipments of the Pentium 4 as the company ramps up volume.

All those factors could affect Intel's ability to meet second-quarter earnings and revenue estimates. Concerns about the quarter already have been surfacing. Earlier this week, Thomas Weisel Partners cut Intel to market perform from buy, saying that the company would fall short of the $6.2 billion to $6.8 billion in revenue it has said it will bring in during the second quarter. (Weisel has done no underwriting for Intel.) That came a few days after rumors began circulating among market players that Intel was going to issue a warning regarding its guidance. It didn't.

Then on May 14, Credit Suisse First Boston began telling clients that Intel's first month was running 30% below expectations, according to Briefing.com. (CSFB's semiconductor research team didn't return calls requesting comment.) Intel declined to comment, but it has said in the past that its pricing was factored into revenue guidance.

The Comparisons

Amid the problems, the constant comparisons with AMD, a rival that once couldn't get its act together, may be the toughest for Intel to take. And investors seem to believe the hype. Since the start of the second quarter, AMD's stock has gained 19%, while Intel's has gained 9%. And since the beginning of the year, AMD has jumped 128%, while Intel has fallen 6%.

Parting Ways AMD's stock has blown past Intel's this year as it has taken market share from the chip giant

That trend may not change anytime soon. AMD has managed to capture investors by pulling in more customers. In the first quarter, AMD picked up about 4 percentage points of market share, according to Mercury Research, though it still trails Intel by a wide margin. Much of the gain came from the faster, high-performance sector where it picked up five percentage points of market share. This is a new market segment for AMD, which has traditionally focused on a slower, value chip.

This week, AMD announced that it was launching a new high-performance chip for mobile applications -- with the strangely familiar name of Athlon 4 -- and that Compaq (CPQ) PCs would use the chip. Weisel's Eric Ross expects AMD to announce next month that it has cracked Dell (DELL). Dell is the only PC maker that uses Intel chips exclusively. And later this year, AMD will launch its first chip for the server market, where it hopes to grab market share as well.

The Response

Intel isn't just standing by, of course. The company is trying to defend its territory by cutting prices and pushing into new markets. It's aiming at the communications market and Thursday announced the launch of a new chip for wireless applications. And it's in the midst of a technological overhaul, changing not one but two major elements of its production process starting this year.

So far it's been well compensated for those efforts. It trades at 51 times 2001 earnings. But the gap with AMD is closing; after years of single-digit price-to-earnings ratios, AMD now trades at 24 times 2001 earnings. Of course, the company still needs to overcome the lingering fear among investors that, after its execution problems in the past, it will fail to come through with the better chips companies now expect from it.

Intel isn't waiting to see how AMD executes. It began slashing prices on its microprocessors early this year and has gotten more aggressive in the past month, introducing sales of its fastest Pentium 4 chip at about $350 -- not the $700 it might've asked for in a stronger market.

That kind of blue light special will take its toll this year. Cutting the price of each chip and enabling the Pentium 4 to move into other, lower markets may help Intel maintain its market share, but both Intel and AMD are going to pay for the lower prices as their profit margins erode. "They are both going to suffer from EPS declines and probably pressure to the stocks as well," says Dan Niles, a chips analyst at Lehman Brothers, which hasn't done underwriting for Intel or AMD.

Possibilities

In the long term, though, the strategy may not be as bad as it looks, Niles says. Intel can easily outspend AMD. Intel had about $11.6 billion in cash and short-term investments at the end of the first quarter, while AMD had about $1.6 billion. And Intel has committed $7.5 billion to capital spending this year, which will give it a leg up over the long haul. The smaller AMD, which had $4.6 billion in revenue in 2000 compared with Intel's $33.7 billion, plans to spend only $1 billion.

The price war comes at a time when both semiconductor and PC makers say that the business is so bad, it must be scraping bottom.

Niles says that Intel had no choice but to cut prices because PC makers aren't buying as many chips as it expected. He thinks the demand for the Pentium 4 is running at about half of what some analysts had anticipated. Weisel's Ross sees only 1 million to 1.5 million Pentium 4 units shipped this quarter and a total of 10 million units for the year -- down from the 20 million that Intel had told analysts to expect.

"There's just no demand for PCs at the high end," Niles said.

Dell seems to agree. On Thursday the company said business can still get worse -- it expects revenue to fall 3% to 5% in the quarter ending in July. During a conference call, Dell was vague about whether turnaround is in the immediate offing, though it was slightly more confident that demand will pick up later this year.

But that's not likely to help Intel out of its rut anytime soon.

>To order reprints of this article, click here: Reprints