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As Intel Pursues Internet Growth, Analysts Question Debilitating Effect on Profitability

As the chip giant moves into the Internet industry, Intel will likely face increased profitability concerns among investors.



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may have dispelled concerns about its fourth-quarter profits in a meeting with analysts Thursday. But in subsequent quarters, as the chip giant's forays into the Internet industry start to show up on its income statement, Intel could find those profitability concerns returning with a vengeance.

Intel's stock rose 7% to 77 7/16 Friday after the company assured analysts that the Taiwan earthquakes and the Y2K problem wouldn't hurt its earnings, and that demand remains strong for its computer and server chips. Those statements alleviated concerns about Intel's profits in the current quarter.

Investors in Intel have developed an addiction to its high profit margins, and the world's largest chip company has managed to feed that addiction quite nicely for decades. This is a company that has considered gross margins of 49% unacceptable. But Intel, on its quest to become the world's largest Internet company, is actively steering investors away from their obsession with profits and toward the Internet metric of revenue growth.

The analyst meeting also contained a subtler yet more significant idea: Intel's Internet business threatens to make high profits in subsequent quarters a more uncertain prospect. And the market's drunken celebration of Intel's short-term outlook today will make the sobering-up that much more painful later on.

"Intel is a cult stock. It's a major core holding for everyone," says

CIBC World Markets

analyst Ken Pearlman. Because of that, "Investors are willing to go along with just about anything." Pearlman, who says the market has long ignored Intel's bearish fundamentals, has held a hold rating on the stock since March 1998. He broke down Friday and boosted his rating to buy. "I give up," Pearlman sighs. CIBC World Markets has no underwriting relationship with Intel.

Intel's drive to shift expectations away from profits became clear at the fall meeting with analysts Thursday. Intel has traditionally held the meeting at a fancy San Francisco hotel, but this year it held it over the Web -- sans cold-cut platters and open to the electronic-trading public. The two-hour session was full of charts that showed high sales growth rates in new areas of networking, communications and Internet services, but no data whatsoever on how profitable these ventures will be.

Of course, no one ever accused Intel of full disclosure. The company is traditionally tight-lipped about forecasting profits. But in past analyst meetings, CFO Andy Bryant would talk at length about profit margins and what the company was doing to fatten them.

This time, Bryant gave no presentation at all, and there was little mention of profit margins. Instead, Chairman Andy Grove and CEO Craig Barrett outlined the company's new growth strategy. As investors in the Internet sector know, a growth strategy starts with training investors to watch revenue instead of profits.

Through acquisitions, about half of the company's future revenue will be in communications-related areas and half will be in traditional chips for PCs and servers. "For the first time ever, our acquisition costs will exceed capital spending for the year," Grove said.

Prominent among Intel's Internet deals are network chipmaker

Level One Communications

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, cellular-phone chipmaker

DSP Communications

, communications-software maker


and Web-hosting company



In the Thursday meeting, there were clear signs that some analysts are growing increasingly uneasy with the uncertainty of Intel's profits. In a question-and-answer session open to anyone who logged on, many of the questions focused on profitability. And many of those questions went without clear answers.

When one analyst asked whether Intel's earnings would be affected by the nine companies that Intel is spending $6 billion to buy this year, Bryant declined to answer, saying that each company acquired presents a different earnings model. "Clearly some of them will take a few years to be accretive," Bryant said.

Similarly, when another listener asked whether server chips on future 64-bit architecture were as profitable as today's chips on its 32-bit designs, Grove declined to answer. Executives also steered around questions about the effect of rising PC prices on Intel's margins.

Drew Peck, an analyst at

SG Cowen

, says that Intel has no choice but to de-emphasize profits. "That's what happens when

average chip prices are admittedly going down and they are acquiring companies right and left and admitting earnings will be diluted." He expects to see lousy profits in the next few years.

"They still have to pay these people in these new companies and still have to invest heavily in R&D," says Peck, whose firm has no underwriting relationship with Intel. Peck, a longtime bear on Intel, turned

bullish this summer and upgraded the stock to buy from neutral before downgrading it back to netural after the company

missed the Street's earnings expectations for the third quarter. Nothing on Thursday's call made him feel any more positive, he says.

"The outlook for 2000 -- I don't want to say grim, but it is certainly questionable," Peck says. "As an investor and analyst, you have to look at the big picture. There are a lot more risks and a great deal of uncertainty about next year."