Rising PC Sales Lift Chip Stocks - TheStreet

Here's a painful disconnect for tech investors to ponder: Leading chipmakers such as

Intel

(INTC) - Get Report

and

Texas Instruments

(TXN) - Get Report

are reporting bodacious third-quarter profit gains. Yet the outfits that buy their silicon, like

Hewlett-Packard

(HPQ) - Get Report

,

IBM

(IBM) - Get Report

and

Gateway

(GTW)

, have seen profitlevels suffer as their PC divisions flail in red ink.

Though chips and PCs are joined at the hip, the disparity shows just how different the two businesses are. Right now chipmakers have the wind attheir back in two big areas: As expensive semiconductor plants kick into overdrive, they're able to manufacture silicon far more efficiently. At thesame time, Intel and others have been able to minimize price declines with upgraded silicon like Wi-Fi-enabled chips, which in turn have prompted more PCbuying.

In contrast, computers are largely commoditized and must grapple with ongoing steep price declines. Adding to the price pressure, the handful of remaining big boxmakers are engaged in a never-ending fight for market share. And even with the upturn, the PC business won't see the kind of manufacturing leverage that semiconductors enjoy.

PC Yin and Yang

The bottom line: Though more and more PCs are being sold, most boxmakers aren't expected to make money from them.

Indeed, last week Bear Stearns boosted its estimates for 2003 PC unit sales growth from 9% to 12%. But in a reflection of the pricing pressure thatcontinues to bedevil hardware markers, the bank actually lowered its revenue growth forecast from a measly 2% to an all-but-invisible 1%.

Its logic: Hardware makers will have to keep wheeling and dealing as PC demand has shifted to consumers, a price-sensitive bunch.

Making matters worse, surviving boxmakers were already engaged in a price lowballing marathon which keeps getting nastier.

Those unhappy trends are abundantly evident in bottom lines at virtually every boxmaker but Dell. For instance:

Gateway reported another loss and warned it might miss estimates for the December quarter.

IBM's PC group reported it was $50 million in the red.

H-P's computer group reported it lost $56 million in the July quarter.

Contrast that ugly competitive picture with the beguiling scene in chipland. Last week Intel reported a spectacular third quarter featuring the best quarter-on-quarter growth in 25 years. Net income skyrocketed 142% from last year's levels.

TI also saw a huge gain in profits (though an apples-to-apples comparison is complicated by a restructuring charge and a large gain from the sale of

Micron

(MU) - Get Report

stock).

Therein lies the disconnect: Instead of simply dropping prices as PC makers have done, chipmakers instead serve up gains in the power and efficiency oftheir silicon.

For that reason, the value of silicon in a $1,000 business system has stayed roughly constant over the past two years, at around $150, points out DeanMcCarron, principal analyst at Mercury Research. But for the same price, a computer user can expect to get a next-generation Intel processor that runs three times as fast.

Intel in particular is famed for its ability to keep prices aloft, combining its marketing brawn with innovations like Centrino, the all-in-one package containing Intel's Pentium M, core logic chipset and wireless LAN silicon. The Wi-Fi-enabled silicon, which now comes embedded in many notebooks, allows wireless Internet access.

"You might call that the core functionality of the mobile PC," says IDC analyst Shane Rau (though he notes that memory is also key). "Intel is doing a lot of the R&D for the whole industry; they're doing value add and charging for that through high microprocessor prices."

Indeed, Intel expects to spend $4.3 billion on R&D this year. To put that in perspective, Dell spent a mere $227 million in the first six months of itsfiscal year.

Another quality that distinguishes big chipmakers from PC outfits, besides their relative pricing power, is an ability to wring big profit gains out ofmanufacturing.

Because making semiconductors is such an intricate process, chipmakers must spend billions on expensive equipment to keep pace with innovations in silicondesign. For example, Intel will plunk down about $3.6 billion to $3.7 billion in capital spending this year.

That makes its profit levels highly sensitive to changes in demand. Because the high manufacturing costs are fixed, profits suffer a lot when unit demandis weak. Intel's gross margins ebbed to 46% in the third quarter of 2001, often viewed as the lowest point of the downturn.

But when demand picks up, as is the case now, profitability surges since it can crank out more chips over the same cost base. Intel expects gross margin of around 60% for the quarter now underway, andanalysts expect a few more percentage points of upside next year.

Texas Instruments saw a similar effect this quarter, as greater manufacturing efficiencies helped spike gross margins by 3.20 percentage points from the prior quarter, to 40.7%. The big increase occurred asrising demand pushed TI to draw on over 80% of its total factory capacity, up from around 75% in the prior quarter.

By comparison, computer makers are much less affected by such manufacturing swings, in part because they invest much less in factory equipment. Dell plansto spend only about $300 million on capital expenditures in its current fiscal year. Lower overhead means there's less leverage to the upside and the downside.

Accordingly, Dell, which manufactures its own PCs, has seen only a muted rise in gross margins gains over the past year, up about 30 basis points to 18.2% in the most recent quarter. (For that matter, a spokesman for Dell notes that the company focuses on improvements at the operating margin level rather than gross margin).

H-P, the other big cheese in the business, outsources the vast majority of its PC manufacturing, so it wouldn't see any margin leverage at all fromrising unit volumes.

In short, the combination of manufacturing efficiency and pricing power gives Intel (and select other chipmakers, including Texas Instruments) thepotential to see big profit gains that PC makers simply can't match.

"If the boxmakers improve, there's more leverage on the component guys," sums up Sunil Reddy, manager of the

(FTTAX) - Get Report

Fifth Third Technology fund. He has holdings in both Intel and TI.

"I'd rather be an owner of Intel than Dell because it's got more leverage through microprocessors, especially now with the

manufacturing technology transition. And nobody out there can catch Intel, whereas on the boxmaker side you've always got H-P andDell duking it out or even some second-tier out of Taiwan competing."