Despite Intel's (INTC) - Get Report touting of its second-quarter results, the sharp run-up in the company's shares stalled Wednesday as investors fretted that the world's largest chipmaker had maxed out its capabilities.

Intel CFO Andy Bryant said as much during the company's conference call late Wednesday. "I've got my factories running full-out right now," he noted.

Intel shares recently dropped 6.1% to $26.96 Wednesday, after hitting a 52-week high on Tuesday.

Capacity is tight at Intel, especially for trailing-edge products such as chipsets and flash memory, which together account for almost 20% of sales. Logic microprocessors, too, are tight.

"We're losing some

chipset revenue we could have had if we'd had a little more capacity," Bryant said on Tuesday.

Intel reported second-quarter earnings of 33 cents a share on sales of $9.23 billion, essentially in line with analysts' expectations of earnings of 32 cents a share on sales of $9.22 billion. "This was a good second quarter, a period when business is typically slow," Bryant said. "The momentum of the first half appears to be continuing as we enter the second half."

The company cited mobile processors as a driver of its results and noted that its dual-core chip ramp is proceeding according to plan and that a refresh of its Xeon server chip line will likely happen ahead of schedule.

However, for all of those positives, inventory declined in a period when it was expected to slightly increase, and the company didn't boost its gross margins for the rest of the year. The latter was a hope that many investors had bet on, driving up the stock almost 30% since mid-April.

Inventories slipped $69 million to $2.7 billion in the second quarter. "Inventories are leaner than I would like," Bryant said. "It will be a challenge to make significant progress in building inventory at the current level of demand."

Indeed, the strongest part of the year is upon the electronics industry, and demand is expected to increase for the next five months. Intel took a step toward boosting capacity by bumping up its capital budget for the second time this year, to $5.9 billion from a previous range of between $5.4 billion and $5.8 billion.

"The increase we're seeing now is a function of the first-half business we've seen," Bryant said. "Chipsets are still extremely tight, as first-half demand was stronger than we expected. If the worldwide economic strength continues without a little more capacity, we could end up in the same situation for the next 18 months. We're trying to give ourselves more headroom."

For the third quarter, Intel predicted sales between $9.6 billion and $10.2 billion and gross margins of 60%, while Wall Street had predicted sales of $9.76 billion. The midpoint of Intel's range indicates that the company feels confident in meeting a seasonal demand increase, but how much more demand it can satisfy is unknown.

The capacity conundrum directly affects Intel's gross margins, and that in turn plays out on Intel's stock price. Working backward, Intel's stock typically correlates with gross margin expansion or contraction, which is in turn driven in part by capacity utilization.

Once Intel reaches maximum capacity, the company's margins could be stuck. The fourth quarter is typically the company's strongest period for margins, but Bryant said that's typically a result of increasing demand and increasing utilization. Intel may have already passed the point of increasing utilization.

"Given the upside in revenue and gross margins the company experienced in first half 2005, we expected higher gross margin leverage; however, it appears utilization rates have peaked and Intel is experiencing pricing pressure which is limiting upside to gross margins," wrote analyst J.P. Morgan analyst Chris Danely, whose firm has received non-investment-banking revenue from Intel in the past year. J.P. Morgan also downgraded the stock to neutral from overweight.

Still, Bryant remained optimistic about current conditions and said that "there are more positives than negatives going into the fourth quarter."

Investors who have run the stock up during the past two months on the chance that Intel could surpass its all-time record gross margins of 62.5% in 2000 lost a battle on late Tuesday when the company merely narrowed its margin targets to around 59%, plus or minus a couple of points, from a previous margin of error of plus or minus a few points.

There's still time for Intel to eke out some extra yield out of its factories or shift some internal capacity, but the company is taking a cautious tone toward those prospects. On Wednesday, investors took their own cautious tone.