Updated from 10:09 a.m. EDT

Intel ( INTC) shares took a tumble Wednesday in the wake of its second-quarter report, recently down $2.43, or 9.3%, to $23.71.

While the chipmaker said silicon demand is holding up, both in the U.S. and overseas, Intel stung shareowners with the news that it would have to lower its profit outlook for 2004 -- in part because internal miscalculations led to an unexpected surge in the company's chip inventory.

The stock was downgraded to neutral by Prudential, Morgan Stanley and Harris Nesbitt Wednesday, and saw earnings estimate cuts at a host of other brokerages, many of whom had earlier recommended Intel on its gross margin leverage.

Other stocks were lower in sympathy, including chip-equipment makers Applied Materials ( AMAT), KLA-Tencor ( KLAC) and Novellus ( NVLS), all of which were recently down over 5%. Advanced Micro ( AMD) was recently down 63 cents, or 4.3%, to $13.87, while the Philadelphia Semiconductor Index was off 4% and the Semiconductor Holders Trust ( SMH) was down 4.8%.

"Intel has always been a gross margin-sensitive stock," pointed out Morgan Stanley analyst Mark Edelstone, in a note downgrading the stock to neutral from buy. While declaring overall margins are still healthy and the stock's valuation is reasonable, he doesn't think the stock can outperform its peers unless gross margins are shooting up or it offers the potential for meaningful earnings upside -- neither of which seems likely at this point.

Gross margins and earnings leverage appear to have already peaked in the current cycle, according to Edelstone, who lowered his earnings estimates for the remaining two quarters of 2004 by 3 cents each. He dropped his earnings estimate for the year from $1.24 to $1.20, though he actually increased his revenue outlook from $34.4 billion to $34.6 billion.

The analyst also brought down his 2005 EPS estimate to $1.35 from $1.45. Morgan Stanley hasn't done recent investment banking for Intel.

Prudential's Mark Lipacis, who likewise knocked down his rating on Intel to neutral from overweight, wrote: "We lowered our price target on Intel with our sector downgrade in April, but kept our overweight rating based on the thesis that increasing gross margins could lead to relative outperformance. But with inventories up 50% and with increased reliance on lower margin revenue products, that thesis appears to be no longer valid."

Lipacis lowered his 2004 EPS estimate to $1.20 from $1.22 and his 2005 estimate to $1.36 from $1.42, citing the lower gross margin estimates partly offset by higher revenue estimates. Prudential doesn't do investment banking.

But Intel bulls persist. At A.G. Edwards, analyst David Wong called the gross margin guidance a temporary setback. "Although we think this will disappoint investors in the near term, we believe that Intel will still be able to achieve record gross margins in 2005," he said, leaving his higher-than-consensus estimates essentially unchanged and keeping a buy rating on the name.

In Intel's favor, Wong noted, the company guided for better than seasonally normal top-line growth. "This implies to us that the PC end markets remain strong and are tracking at growth that is slightly better than seasonal," he wrote. "Intel indicated that it sees no barriers to eventually achieving its long-term cost goals on microprocessors, which leads us to conclude that Intel will still be able to achieve record profitability in 2005." A.G. Edwards has no investment banking relationship with Intel.

Little Cause for Concern

Notwithstanding the harsh selloff, there was decent news to be gleaned from the report. The drop-off in gross margin guidance partly reflected unexpectedly strong yields, as Intel chip plants adopt complex new manufacturing techniques. And the Santa Clara, Calif.-based chipmaker matched Wall Street's expectations on sales and earnings and issued robust sales guidance for the quarter now under way.

Asked to comment on the general state of tech demand, Chief Financial Officer Andy Bryant said on a postclose conference call that the slew of recent software earnings preannouncements "give you a little cause for concern, but inside our business we're seeing no evidence of a problem."

In a separate comment, President and COO Paul Otellini said: "We still see strong year-over-year growth in consumer and corporate buying in the U.S."

Intel said after the market close that its second-quarter profit totaled $1.8 billion, or 27 cents per share, up 96% from last year's levels but in line with the consensus estimate.

Sales grew 18% to $8.05 billion, a hair below the consensus number for $8.10 billion. Intel forecast sales of $8 billion to $8.2 billion in its June midquarter update.

Gross margins totaled 59.4% for the June quarter, below Intel's guidance for margins of 60% to 61%. The shortfall was because of a $38 million charge to recall Intel's Grantsdale chipset, announced in June, and because second-quarter revenue came in slightly below the midpoint of the updated range.

In a comment that deeply rattled Wall Street, the company dropped its gross margin outlook for 2004 by 2 percentage points, saying it now expects an average margin of 60%, plus or minus a couple of points, rather than 62%.

Intel was forced to lower its sights in part because chip inventory surged by 15%, or $427 million higher than the company had anticipated at its last earnings call in April. The buildup in microprocessor inventories reflected bumper yields on Intel's Prescott chip, which is produced using leading-edge manufacturing techniques.

In a candid exchange underscoring analysts' surprise at the leap in inventory, Merrill Lynch analyst Joseph Osha said to Intel officers on the conference call, "I've never seen you misjudge your output this massively. Are you saying all this run-up in inventory simply comes from more stuff coming out the end of the pipe than you thought?"

Bryant answered in the affirmative, pointed out that plenty of sell-side analysts (and even Intel managers) were concerned as recently as February that the company would encounter problems as its chip plants shifted to producing chips with 90-nanometer linewidths on 300-mm wafers. He called the unexpectedly good yields "one of the good surprises you have to figure out how to deal with."

But the downside of high yields is that Intel's profit levels will take a hit as it works off inventory in the months to come. Because Intel plans to slow the number of wafer starts, costs such as depreciation, labor and overhead will be spread across a smaller number of products than initially planned, Bryant explained.

To be sure, not all of the inventory buildup was because of Intel's miscalculations. Some of it simply reflects the rollout of several new chips. "Part of the issue here is that they are ramping up new products, with the Grantsdale chipset and both Dothan and Prescott processors. So some of that inventory build is to support a very aggressive back-to-school and holiday cycle," said Krishna Shankar of JMP Securities.

"Only time will tell whether consumers step up," he said, adding that he's optimistic about demand. (Shankar has a buy rating on Intel; his firm doesn't do banking for Intel, but he owns shares himself.)

When the Chip Comes Down

Besides the inventory jump, there are other reasons for the dropoff in gross margin guidance. One is that Intel has seen pressure on average selling prices as it sells more goods into emerging markets, which tend to favor lower-priced desktop PCs over notebooks, explained Otellini.

Also, Intel has finally revived its flash business, which had struggled for a series of quarters after an ill-timed price hike last year. The chipmaker said it now expects faster growth in flash memory, as well as in chipsets and motherboards -- all of which carry lower profit levels than Intel's flagship microprocessor line does.

On the upside, the stronger flash outlook means Intel will see a benefit to revenue and operating profits, pointed out Shankar.

In a related bit of upbeat fundamental news, after the close, Intel forecast third-quarter sales in the range of $8.6 billion to $9.2 billion, in part due to the sturdy outlook for flash. The midpoint of the guidance, $8.9 billion, is above the Wall Street consensus estimate for $8.76 billion and implies sales growth of nearly 10%.

Leading up to Tuesday's call, analysts had speculated that Intel might guide to anywhere from 5% to 10% sequential growth for the September quarter.

To put that in context, over the past five years, third-quarter sequential growth has ranged from 3% to 15%, with an average of 7% growth, Bryant said.

The main reason for higher-than-normal quarterly growth is that Intel expects "strong growth" in flash memory, with expectations for continued market share gains in flash, chipsets and motherboards. Bryant said that microprocessors should grow at a rate that's seasonal to slightly above seasonal.

"Everything out there is behaving right now normal to slightly positive. If you take that as a baseline and add in market share gains, that's how you get to a stronger-than-normal quarter," he said.

Analysts were expecting earnings of 32 cents on the now-outdated consensus estimate; however, Intel does not offer separate earnings guidance.

Intel also forecast a third-quarter gross margin of 60%, plus or minus a couple of points.