SAN FRANCISCO -- If Intel ( INTC) hoped to calm investor jitters about the health of the PC market, it failed. The company's stock plunged nearly 12% a day after its fourth-quarter earnings report , as Wall Street put more weight into the below-seasonal sales guidance than in CEO Paul Otellini's assurances that business was in good shape. But for some investors, the real puzzle in the wake of Intel's earnings report involves the chipmaker's profit margins.
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"They gave all these reasons why their gross margins were going to improve and then basically guided to flat gross margin," says one hedge fund analyst who asked to remain anonymous. The seeming contradiction prompted much consternation among investors, who looked for various explanations for the tempered margin, ranging from the arrival of a new finance chief to Intel's recent legal issues. "They Intel didn't do a good job of explaining it, and that's why people are coming up with all sorts of weird theories," says a manager at another hedge fund. "Everybody's guessing beyond this point." After boosting its fourth-quarter gross margin to 58% -- the highest level since the fourth quarter of 2005 -- Intel predicted a dip to 56% in the current quarter, and 57% for all of 2008. In other words, there's no gross margin upside left for at least the next year. That's particularly striking, given that Intel has been in the midst of a major restructuring designed to improve its profitability. Intel has reduced its headcount by 14% in the past two years, and jettisoned various money-losing businesses, including the NOR flash memory group in a deal that's expected to close this quarter. With little cost-cutting ammunition left, there's a sense that Intel's mission to improve its margins is already in the ninth inning -- and that this is as good as it gets. In his first conference call since replacing longtime Intel CFO Andy Bryant, Stacy Smith struggled to answer analysts' questions about the seemingly stalled margins, maintaining that there were no negative factors holding the margins back. The only wild card that could swing the margin in either direction, Smith said, is pricing. The company of course, didn't provide an outlook for pricing, although Otellini did appear to be preparing the Street for declining prices of its notebook chips. "As mobile continues to grow as a fraction of the PC market, system price points have expanded to include new lower prices," he said, noting that the company's forthcoming Silverthorne processor will allow it to maintain solid margins even with low prices. Chip prices also tend to fluctuate as competition heats up, as evidenced by the fierce price war that Intel waged with Advanced Micro Devices ( AMD) in 2007. With Intel under increased antitrust scrutiny -- most recently from New York's attorney general -- some investors speculated that the chipmaker might be less likely to price as aggressively as in the past. That would argue for rising chip prices, and more improvement to the gross margin. On the other hand, Avian Securities head of research Avi Cohen reasoned that a rapidly rising gross margin would also not reflect well on Intel's role as the world's dominant maker of PC microprocessors. "Given the growing anti-competitive scrutiny INTC is currently receiving from the State of NY and the EU it should have been clear that INTC didn't want to publicly flaunt improved gross margin guidance," Cohen wrote in a note to investors Wednesday. For Pat Adams, chief investment officer of Choice Funds, Intel's 57% margin target is more a reflection of prudence than a lack of upside potential.