Intel Rises After Its Upside Surprise - TheStreet

Updated from July 15

Intel

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shares gained 4% a day after it pulled off upside surprises on sales and profits for the third quarter in a row, while issuing slightly better-than-expected guidance. It also boosted its estimate of profit margins for 2003 by two full percentage points.

In recent trading, the stock tacked on 97 cents to $25.07.

The strong June quarter prompted upgrades at Bear Stearns and Friedman Billings Ramsey, which both raised the stock to outperform from neutral ratings. At Bear, analyst Gurinder Kalra said he expects Intel to outperform the rest of chip stocks. "Intel's second quarter results demonstrate Intel's execution in a period when a recovery in IT spending is a question mark," he wrote. Bear Stearns hasn't done banking for Intel.

Intel reported second-quarter revenue of $6.8 billion, 8% above the level of the same quarter a year ago and a tad above Wall Street consensus estimate for $6.7 billion.

Gross margin in the period totaled 50.9%, slightly below last quarter's 52%.

But in a move sure to be applauded by investors, Intel said its margin should rise to 54% in the third quarter, citing higher expected revenue, lower start-up costs and lower unit costs.

Intel forecast that margins should stay at the 54% level for 2003 as a whole, 2 points better than the 51% it had previously forecast.

In the second quarter, net income of $896 million amounted to 14 cents per share, flat sequentially and double last year's levels. Analysts were gearing for 13 cents a share.

As is its normal practice, the chipmaker issued a wide range of guidance for the third quarter, projecting sales to fall between $6.9 billion and $7.5 billion. The midpoint of that range, at $7.2 billion, falls slightly above Wall Street's consensus estimate for $7.1 billion.

"The highlight obviously is the guidance and the gross margin expansion," says Sunil Reddy, manager of the

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Fifth Third Technology fund, which has a stake in Intel. "Right now it's firing on all cylinders."

Even with the stock soaring north of $25 in after-hours trading, he said, "I wouldn't be hesitant to add to it now. It's in a very good position architecturally with a road map for the long term. It's made a lot of countercyclical investments that people criticized at the time, but they're paying off now."

Pacific Crest analyst Michael McConnell called the results "nothing short of spectacular." His firm hasn't done banking for Intel.

"They are definitely benefiting from an improved product mix, Centrino as well as Xeon on servers. But the big number is obviously the 54% margins, far above anyone's expectations in terms of guidance," he says.

On top of that, says McConnell, "The outlook for the third quarter off the higher base in the second quarter is very encouraging. They're not only seeing higher units, but they're realizing the benefits of

manufacturing investments they made so aggressively in 2001 and 2002."

On the conference call, Chief Financial Officer Andy Bryant agreed, explaining that more efficient manufacturing will help it lift margins even though third-quarter sales aren't on pace to be better than usual.

"We have factory investments over the last two years and things are happening that allow us to take some share and have a couple quarters where ASPs are flat. A lot of good things are happening right now," said Bryant.

At the same time Intel's manufacturing yields have been improving, it's also been shifting to a production process that allows it to cut chips from big, 300-millimeter sized wafers, which produce nearly 2.5 times as many chips as the more common 200 millimeter size.

Still, it's worth noting that in order to claim 54% margins for the year, Intel will have to hoist its margin to over 57% in the fourth quarter, observes Lehman's Dan Niles. That implies almost 100% of additional revenue drops through to gross profit dollars -- no easy task, though Intel has managed to secure impressive profit leaps in the past.

Also on the margin front, Niles points out that some of the profit gains will take place simply because of an accounting shift, as the company transfers the cost of engineers (who were previously busy working on its 90 nanometer manufacturing technology) from the cost of goods line on its balance sheet into the R&D line (as they start work on developing a more advanced technology, 65 nanometers).

Aside from the gross margin surprise, the rest of Intel's results were about on par with what Niles was expecting -- and he notes that the company managed to beat EPS expectations via a tax benefit, rather than through performance upside. Niles, who upgraded Intel to a buy last summer, says the latest results aren't an anomaly, but rather reflect a gradual rebound. "We're getting back on the recovery path that the war and SARS kind of disrupted," he explains.

In that vein, President Paul Otellini said sequential growth in the June quarter reflected "a good result in what is normally a seasonally down quarter." By geography, Asia Pacific set an all-time revenue record, even after taking a modest hit from SARS.

By business, Intel's microprocessor arm turned in a performance at the high end of seasonal patterns, managing to hold units flat. Sales in the division grew 12% from the same quarter a year ago, while profits were up nearly 35%.

Growth in chips helped offset weakness in wireless communications, which saw a revenue drop off of 13%, and communications, which fell 5%. Both divisions saw losses widen from a year ago.

By product category, Intel said unit sales and average selling prices of its microprocessors stayed flat with the prior quarter. Chipset units likewise stayed flat. Motherboard units were higher, and Ethernet connectivity products also rose slightly, while flash memory units dipped.

But Intel execs stressed on the conference call that its strong performance reflects the company's own payoff on investments and shouldn't be taken as a sign of an improving macro environment.

"We're trying to communicate that we're not seeing signs of economic recovery here," said Bryant. "We're not seeing a big upgrade cycle; we're not seeing IT budgets being raised suddenly. If you look at a 10-year history for Intel, the second halves grow more than the first halves shrink. In the last two years, they've offset each other with no growth."

"I think we're returning to a more seasonal pattern. In the second half, growth will hopefully be more than the first half shrinking," he said, but added, "If we saw an upgrade cycle or IT budgets going up, you'd see us becoming more positive."

Yet while Bryant sounded a note of restraint, Intel's own employees are already feeling a morale boost, courtesy of the company's improving profits. The chipmaker said today it will reinstate a program that provides each worker with a free computer for use at home.

Intel had put the program on hold in 2001, after handing out PCs to half its employees, when it decided to ax all nonessential spending. "We're trying to fulfill a commitment we made, at a time our margins are going up," explained Bryant.

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