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Intel's Good Looks Could Deceive

The chipmaker may have caught rival AMD, but an inventory glut could bite its bottom line.

For most of the year, Intel (INTC) - Get Intel Corporation (INTC) Report could do no right in investors' eyes.

But after

tightening its belt with layoffs and spending cuts, and creating excitement about its technology for the first time in years, Intel may have done its penance and may be ready to rock and roll again, some investors say.

A trickle of buy notes from Wall Street analysts has rehydrated the stock, which is up 28% over the past three months. All of a sudden there's even talk of upside to the third-quarter results.

"A solid seasonal rebound in the PC market should allow INTC to hit the high end of, or slightly above, its guidance range," American Technology Research analyst Doug Freedman wrote in a recent note to investors, in which he boosted his price target from $24 to $26 and maintained his buy rating.

Of course, beating the guidance hardly seems a feat worthy of popping the champagne cork.

Just about every financial metric in the third quarter will be significantly lower than the results from a year ago.

The average analyst sales expectation of $8.6 billion is roughly 7% lower than the $9.2 billion Intel generated in the third quarter of 2005. EPS is expected to come in at 18 cents vs. 33 cents a year ago.

And Intel's own estimates peg third-quarter gross margin at 49%, plus or minus a couple points. At this time last year, the chipmaker had gross margins of 59.7% (61% excluding the impact of a legal settlement).

As Bad as It Gets?

Whether this is as bad as it gets will become clear Tuesday when Intel provides updates on key aspects of its business. Topping that list will be inventory.

During the second quarter, Intel's inventory surged 58% year over year to a whopping $4.3 billion. Management explained the rising chip stockpiles as a normal buildup to prepare for the upcoming holiday sales season.

The problem is that even Intel's most optimistic revenue forecast calls for only an 11.2% sequential pickup in sales during the third quarter.

In other words, Intel's inventory going into the third quarter was nearly $1.6 billion larger than it was at the same time last year, even though the company expects only an additional $300 million to $900 million in business during the quarter.

Intel may be beefing up its supply of popular new processors such as the Core 2 Duo, but the company also appears to be sitting on a substantial pile of older chips whose shelf life is quickly expiring.

To unload the goods, Intel has been aggressively slashing prices. At some point however, the company could be forced to bite the bullet and take a write-off.

Because the third quarter is already wrecked, now might not be a bad time to take the hit, say some analysts.

TheStreet Recommends

"We think that investors would view a large inventory charge by Intel as a positive action, but we do not have a good feel as to what Intel will decide to do with regard to this," A.G. Edwards analyst David Wong wrote in a recent note to investors. (A.G. Edwards has provided non-investment banking services to Intel within the past 12 months.)

The third quarter also will represent the first full quarter of sales since Intel began refreshing its product lineup. Intel lost ground to rival

Advanced Micro Devices

(AMD) - Get Advanced Micro Devices, Inc. Report

over the year, as computer users favored AMD's dual-core processors.

But this summer, Intel rolled out a lineup of processors that featured a new microartchitecture and impressive performance.

Most industry observers believe that Intel has closed the performance and technology gap with AMD, if not taken the lead with its Core microprocessors. The question is how quickly this will translate into market share and revenue gains for Intel.

Investors will focus on Intel's

Woodcrest server processor, or Xeon 5100, which was launched in June and is the only one of the company's new microprocessors that has been shipping for the entire third quarter.

At Intel's developer forum last month, the company said it has shipped 1 million Woodcrest chips, accounting for half of its Xeon dual-processor chip sales, according to A.G. Edwards' Wong.

"These numbers are consistent with a reasonable, but not a particularly strong, quarter of dual-processor server sales, and we expect that Woodcrest will show a stronger ramp in the December quarter, helping Intel gain share against AMD in the dual-processor server space," said Wong.

Looking further out, there's a growing sense on the Street that Intel's stars will align in 2007 when a strong lineup of chips, the effects of a massive restructuring and the launch of

Microsoft's

(MSFT) - Get Microsoft Corporation (MSFT) Report

Vista operating system will combine to lift the company's fortunes.

But this optimistic view may overlook the fact that the microprocessor market has fundamentally changed and is unlikely to revert to an Intel-dominated monopoly.

Thus, the price wars that have pressured Intel's margins in 2006 could continue in 2007.

If that's the case, the good old days of big earnings and share valuations could remain a distant memory, no matter how fast its chips are.