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Intel's Mobile Business Loses a Bundle -- So What?

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Intel (NASDAQ: INTC  ) , the chip giant well-known for its PC and server processors, has spent the last several years investing heavily in mobile computing. This means mobile system-on-chip products, cellular modems and RF, and low-power processor IP. Unfortunately, as the old saying goes, you need to spend money to make money. In the most recent quarter, Intel's Other IA group, which includes tablets, phones, modems/RF, and everything else mobile, posted an operating loss of $606 million, or $0.12 per share.

This had led many to freak out. But really, there is very little cause for concern. Investments typically precede sales -- and ultimately profits -- and that's exactly what's happening here. In fact, if Intel weren't investing heavily in this division, the company would never participate in the huge growth of mobile computing -- something that would doom the company in the long run. So, just where is all of this money going?

If it computes, it needs to connect
Intel's heritage has largely been as a computing company -- and a great one at that. While in the traditional PC space, performance per watt on the computing side of things -- both CPU and graphics -- is usually all that matters. In all things mobile, it's much more than that -- it's about connectivity. A cell phone is useless without a cellular radio, and it would be very difficult to convince anybody to buy a phone or a tablet today that didn't include Wi-Fi and GPS (the jury is still out on NFC).

While Broadcom and Qualcomm (NASDAQ: QCOM  ) are experts at this sort of thing, Intel is a relative newcomer. As late as 2009, all Intel had in-house with respect to connectivity was Wi-Fi for PCs. Since then, Intel has made numerous acquisitions, most notably Infineon Wireless in late 2010, to become not just a processor company, but a wireless communications company. While it has been -- and continues to be -- an uphill battle, Intel will finally be shipping LTE cellular solutions with its apps processors by the end of the year, with an updated version in the first half of 2014.

This, of course, costs money. Hiring world-class RF engineers and giving them the tools to succeed isn't cheap, which is a big contributor to the dramatically increased operating expenses in Other IA. But that's not all.

Low-power CPU, graphics, and other IP
While Intel needed to spend money to build its connectivity portfolio, it also needed to develop the in-house capability to put together a cost-effective and low-power system-on-chip. In addition to the capabilities required to piece together such complex silicon, Intel also needed to develop the right IP blocks to integrate. That means competitive low-power processor cores, graphics, image signal processors, and more. While the cost to do any of these things once isn't all that terrible, having a pipeline of competitive products set to compete year after year requires consistent investment.

So, when does it get better?
As previously mentioned, Intel's mobile division lost a whopping $606 million on revenues just north of $1 billion. Compare this to Qualcomm, the world's leader in smartphone processors and modem chips. In its most recent quarter, Qualcomm earned $738 million on revenues of $4.2 billion. Looking at Qualcomm's gross margin in this space suggests that a successful mobile modem and apps processor business can run at a 42% gross margin rate. This estimate may be too conservative for Intel as Qualcomm really does play in the very lowest end of this market, and it does outsource the manufacturing, packaging, and testing of its chips, so let's say Intel can be a competitive player at a 50% gross margin.

Assuming there are no material incremental operating expenses, Intel would need to almost double its Other IA group revenues from around $4 billion to around $7 billion annually in order to break even. This isn't actually as daunting as it seems. As the company ramps ups its tablet and smartphone chips throughout 2014 and continues to grow its embedded business, doubling the business from this very low point isn't unreasonable over the next year or maybe two. The pain will end soon and even getting to break-even gets Intel shareholders a whopping $0.40 per share back in operating income.

Foolish bottom line
Displacing the incumbent Qualcomm in the mobile world will be difficult, and developing connectivity solutions competitive with those from both Qualcomm and Broadcom will prove a challenge. But the investment being made here is genuine and gives Intel every chance to succeed. No guarantees, but Intel is at least investing at the right rate. While scaling back these investments could lead to short-term profitability gains, it would ultimately mean that Intel won't be competitive in this space, something that would kill the Intel investment thesis. 

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