Intel: What Went Wrong

Some say a consolidating PC industry is taking a toll.
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Updated from 11:49 a.m. EST

Invstors were looking for answers a day after

Intel

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stunned the Street with a fourth-quarter miss and a bleak outlook for the current quarter.

Intel shares tanked as the predictable downgrades poured in. Citigroup cut the stock to hold on concerns about the chipmaker's near-term profitability and ability to estimate reseller inventories. UBS and Piper Jaffray did the same, citing the potential for weakening growth and gross margins.

In midday trading Friday, Intel shares were down $2.98, or nearly 12%, to $22.54. That followed the stock's 9% drop in extend trading Tuesday after the release of the financial results.

Intel said Tuesday that fourth-quarter earnings rose 16% to $2.45 billion, or 40 cents a share, missing estimates by 3 cents due to a shortfall in sales of microprocessors for desktop computers. Fourth-quarter sales rose 6% to $10.2 billion, well below the company's previous estimate of $10.4 billion to $10.6 billion and the Wall Street consensus estimate of $10.56 billion.

The outlook for 2006 is equally bleak, with Intel projecting that annual growth will dip into single-digit territory for the first time in three years. The bundle of bad news sent shares of Intel plunging $2.90, or 11.4%, to $22.62 early Wednesday, their lowest level since early November. Shares of other computer-oriented companies including

Microsoft

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and

Dell

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took collateral hits.

For analysts and investors who expected 2006 to be the year in which new products helped Intel regain its stride, Tuesday night's report was a splash of cold water.

"We continue to believe additional downside to estimates is likely due to a continued inventory correction and excess processor capacity in 2006," wrote J.P. Morgan analyst Christopher Danely in a note. (J.P. Morgan has been involved in a public offering of debt of equity for Intel within the past 12 months.)

The big question confronting many investors centered on how much of Intel's woes stem from weak market demand and how much are the result of poor execution within Intel.

Intel suggested that both factors were at play in its post-earnings conference call Tuesday, citing its own ongoing inability to produce enough chipsets, an inventory build among customers and soft demand for desktop PCs.

But some people noted that there's been little evidence suggesting a major drop-off in PC demand. "You can't totally dismiss that possibility, but it hasn't shown up in other data points, such as the production and shipment numbers coming out of Taiwan," says Bill Gorman, VP of equity research at PNC Advisors, which owns Intel shares.

Indeed, according to a Jan. 11 note by AG Edwards analyst David Wong, shipments of Taiwanese motherboards increased 22% year over year in November and 25% year over year in December, suggesting solid desktop demand.

PNC's Gorman says he is still analyzing Intel's report and is waiting for reports from AMD and Apple, among others. But he noted that the recent dynamics in a consolidating PC market could be affecting Intel.

"You have

Hewlett-Packard

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, which is a clear No. 2, which has been moving product designs to AMD. Lenovo and Acer have been moving some product designs

to AMD. And Dell has stayed with Intel but has been putting some pressure on them in pricing," says Gorman. As a result, he says, Intel's market-share loss and decline in the average selling price of its microprocessors are not entirely surprising.

After years of effectively owning the PC microprocessor market, Intel appears to have been caught off-guard by the suddenly fierce level of competition.

Until now, Intel's performance has mostly been measured by how fast the market is growing, says Sunil Reddy, senior portfolio manager at Fifth Third Asset Management. Now the company is dealing with the novel factor of market share, says Reddy, whose firm owns Intel shares.

If Intel didn't take the AMD threat seriously enough before, however, the company left no doubt about its intentions going forward, proclaiming that it will boost capital spending and R&D 19% and 27% respectively in 2006, even at the cost of lower gross margins.

"Now it becomes interesting," says Fifth Third's Reddy. "Intel has upped the ante by increasing their capital expense plans. More so than in any other area, in the microprocessor area having leading-edge manufacturing is key."

The goal is to accelerate development of advanced chips with 45 nanometer circuits, a generation ahead of the 65-nanometer chips that Intel is currently transitioning to. By contrast, AMD is not expected to move to 65 nanometer processors until the second half of 2006.

"No semiconductor company with the exception of Samsung can match this pace of leading-edge fabrication expansion," wrote Moors & Cabot analyst Hans Mosesmann in a note. "We believe AMD is now roughly 1 year behind Intel in processing technology, in 2007 they will be 1.5-2.0 year behind Intel."

As if to prevent a repeat of Tuesday night's disaster, Intel declared that it would no longer provide midquarter updates. The company earned 40 cents a share in the fourth quarter.

"Although the year did not finish as strong as we expected, we look forward to a year of solid growth in 2006, thanks to a very strong product road map," said Otellini.

Intel recorded $38.8 billion in sales for its full 2005 year, up 13.5% from 2004. The company earned $8.7 billion in net income, or $1.40 EPS.

But the company outlook for 2006 was not very inspiring, with annual revenue projected to increase between 6% and 9%, after three consecutive years of double-digit growth. Intel CFO Andy Bryant said the pace was somewhat slower than in recent years due to the outlook for the worldwide economy in 2006.

That Intel offered full-year guidance marked a change from its recent practice of making forecasts strictly for the current quarter. Otellini said the company had decided to revert to an earlier practice of providing full-year guidance, while doing away with midquarter updates, in order to foster meaningful discussion about the company's long-term strategy instead of focusing attention on short-term results.

The company also projected that revenue in its first quarter of 2006 will be between $9.1 billion and $9.7 billion, below the average analyst expectation of $10.05 billion. Gross margin for the first quarter was pegged at 59%, plus or minus a couple of points.

The forecast stood in sharp contrast to what the Street expected to hear from Intel.

With a slew of recently unveiled products, and new customer

Apple Computer

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shipping Intel-based Macs earlier than expected, many analysts and investors expected the first quarter to be the point at which Intel would rediscover its stride.

But according to Intel, a worse-than-expected inventory buildup among Intel customers is limiting new orders for the company's microprocessors. That inventory build means that sales in Intel's first quarter could be off by 8% -- the midpoint of its guidance -- vs. Intel's historical first-quarter seasonal decline of 5%.

For its fourth quarter, Intel attributed flat sequential sales in the Asia Pacific region, and a 3.5% sequential decline in sales in the Americas region, to lower-than-expected demand for desktop processors among certain OEM customers.

Sales in Intel's desktop microprocessor group, which accounts for the company's largest source of revenue, were down 6.2% from the year-ago period. Notebook processor sales during the quarter, on the other hand, jumped 40% from a year ago.

Overall, the company shipped more microprocessors than ever in the quarter. But the average selling price of its microprocessors experienced a slight decline in the quarter, Intel said.