Margins May Be Difference at Intel - TheStreet

Margins May Be Difference at Intel

Some expect the chip leader to show impressive improvement in its gross margins.
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hitting a 52-week high on the eve of its earnings report, there's no question it must meet high expectations. Not everyone is convinced the chipmaker can deliver enough good news to sustain its impressive stock performance, with shares having surged 54% year to date.

On the other hand, it might be a mistake to bet against Intel, which has caught analysts off guard with unexpectedly upbeat news for two quarters running.

Monday, Merrill Lynch issued a note arguing Intel may once again trump its rivals by showing sturdy improvements in gross margins over the next six to eight quarters. Contributing to the upside: better average selling prices, due to growing sales of notebook computers, and the debut of Intel's higher-priced Pentium M processors.

On top of that, Intel is likely to benefit from declining depreciation and the shift to a more efficient manufacturing process. The combination, says analyst Joseph Osha, "should allow Intel to generate more gross margin improvement during 2003 and 2004 than the Street expects."

He thinks Intel could post margins of 56% in 2004 and 52.3% this year, compared to a showing of 52% in the most recent reported quarter. His firm has done banking for Intel.

Lehman's Dan Niles likewise expects Intel to show progress on profitability, with gross margins possibly rising 1% to around 51% in the September quarter (though because operating expenses may also rise, he doesn't expect to lift his own EPS estimates by much).

As for sales, Niles expects guidance with a midpoint for growth of 7%, or $7.2 billion. That matches the average sequential growth for the third quarter over the past seven years and is slightly above the September consensus estimate for $7.1 billion.

Meanwhile, for the quarter ending in June, Wall Street expects Intel to show sales growth of just over 6% from last year's levels, to $6.7 billion. Earnings are expected to notch 13 cents, up from 9 cents a year earlier.

Happy Talk

The question is whether Intel can satisfy investors itching for upbeat talk on the second half.

Even Niles thinks investors may feel some disappointment given their high hopes. "The stock probably consolidates on what some may consider 'not enough upside'", he predicts. If that happens, he recommends buying on weakness based on his macroeconomic thesis: "We are in the early stages of a corporate-profits recovery driving an IT-spending recovery," he explains. Lehman has done banking for Intel.

But other analysts sound more standoffish on the shares because of their valuation -- even though they acknowledge Intel has shown up its peers.

At Fulcrum Global Partners, analyst Clark Ruhs agrees that a richer mix of laptop processors, courtesy of Centrino, should lift gross margins above the 50% mark. But he's staying neutral on the shares, saying Intel doesn't look like a bargain given its near-term prospects.

"There is optimism about a strong second half and Intel is clearly in the midst of a laptop processor product cycle; however, we are still not convinced there will be a strong enterprise demand driver emerging in 2003," he says in a note. Fulcrum doesn't do banking.

Echoing his take, Sanford Bernstein's Adam Parker writes, "We urge caution on the stock and would advise managers who are overweight Intel to trim back to market weight going into the earnings reports." Sanford doesn't do banking.

Even assuming Intel can hit his own '04 EPS estimate of 89 cents -- above the consensus estimate for 81 cents -- Parker thinks the stock's valuation looks "stretched." The shares traded hands at a forward P/E of 26.9 based on Monday's close of $24.02.

A Bear Trap

All that said, investors should take the negative comments with a grain of salt, since Intel has managed to surprise a too-bearish Wall Street for two quarters running.

Most recently in April, analysts were gearing for the company to guide second-quarter revenues below consensus expectations. But in a surprise move, it beat sales and profit expectations and issued better-than-expected guidance.

The same thing happened in the preceding quarter, when Intel also delivered solid upside surprises on sales and earnings.