Price Cuts Pinch Intel

In a price war, everybody loses.

This grim reality appears to be sinking into the minds of investors, following Intel's ( INTC) earnings report Wednesday.

The Santa Clara, Calif., chipmaker has been furiously slashing prices to clear out old inventory and put pressure on rival Advanced Micro Devices ( AMD).

But while the price-cutting has taken a toll on AMD, which is set to report its own second-quarter earnings report after the bell today, Intel is not exactly thriving either.

Instead of its second quarter marking the low point of Intel's financial crisis, the company said it expected more hard times ahead.

Intel once again pared back its guidance for full-year 2006 revenue, saying it will be lower than the $38.8 billion it forecast in April. While Intel entered the year predicting 6% to 9% revenue growth, it now looks like revenue could be as much as 10% lower than 2005, say some analysts.

"This isn't a stock I would start to buy again until these earnings revisions stop," says Michael Church, portfolio manager at Church Capital Management, which owns a small stake of Intel shares.

Shares of Intel recently slipped 94 cents, or more than 5%, to $17.55 in midday trading Thursday.

The culprit appears to be what Intel describes as an "unusually competitive pricing environment" that is compressing the average selling prices of its various microprocessors and eroding margins.

What's spooking investors is that Intel's price cuts are looking less like an offensive tactic and more like a defensive reaction that's largely out of the company's control.

"Had they come out and said that a lot of the ASP decline was attributable to their own decision to make an attack on AMD, the market would have been more forgiving," says Church.

AMD has gained market share over the past 12 months, thanks to its server and desktop microprocessors, which many believe provide better performance and energy efficiency than Intel's offerings.

With its new generation of microprocessors hitting the market this summer, many analysts expect Intel to retake the performance crown. But it's unclear whether this performance advantage will confer any kind of price premium and bring Intel's profit margins back to their historical levels, given the ongoing price war.

"The problem is Intel and AMD have different views on what a détente would be," says Atlantic Trust Stein Roe's Fred Weiss, whose firm has an underweight position in Intel shares.

Rather than peacefully co-exist with Intel and maintain a roughly 20% share of the market, AMD is gung-ho on capturing 30% of the microprocessor market. The result is tit-for-tat price reductions, as each company tries to undercut the other to gain share, and customers who are all too happy to exploit the situation.

"If it comes down to price, and you've got somebody who thinks their rightful share is a much higher number, that's going to be very bad for both players in the long run," says Weiss.

Intel's second-quarter finances offer a picture of how it plays out. Profit plummeted 57% year-over-year to $885 million, or 15 cents a share. Gross margin of 52% was not as a bad as the expected 49%, but down from the 56% level in the year ago period.

Sales fell 13% year over year to $8 billion, below analysts' expectations, and at the bottom of Intel's guidance.

Intel is in the midst of an internal reorganization to reduce its cost structure and refocus the company's chip efforts on the personal computer. In June, Intel sold its handheld communications and application processor business to Marvell Technology ( MRVL) for $600 million. And the company has announced it will lay off 1,000 managers.

Intel also announced several changes in its senior management ranks Thursday morning, which it said were designed to achieve "faster and better decision making." Among the changes, Intel promoted Sean Maloney, previously the head of the mobility group, to the company's chief sales and marketing officer. Eric Kim, who was co-manager of the sales and marketing group, will manage the digital home group.

The company also announced the retirement of William Siu, the general manager of the channel platforms group, and Richard Writ, the co-general manager of the software and solutions group.

Intel bulls believe the various internal changes and the new product lineup will eventually manifest themselves in Intel's market share and financial reports.

"Assuming we are not heading into a recession (which may yet be a big assumption), we believe Intel will emerge a much leaner, more effective competitor," said Stifel Nicolaus analyst Cody Acree in a note to investors Thursday morning. Stifel Nicolaus makes a market in Intel shares and has provided the company with noninvestment banking services within the past 12 months.

Acree lowered his 2006 and 2007 profit and revenue estimates for Intel, based on the company's latest guidance, but continues to rate Intel shares a buy.

"Although Intel's report could scarcely be defined as a catalyst for its shares," Acree wrote, "we do believe the firm is 'rounding the corner' and quickly approaching a gross-margin expansion, magnified by operation-expense reduction and highlighted by meaningful share gains."

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