Tuesday, May 19, 1998

Cash-King Portfolio Report
by Rob Landley

Austin, TX (May 19, 1998) -- I wanted to avoid talking about Intel (Nasdaq: INTC) this week since I spent so much of my last turn discussing it (cf. Past C-K Columns). But last week Merrill Lynch analyst Tom Kurlak announced that he was worried that Intel has gotten too good at making computer chips. That illogical little announcement helped drive the stock price down over 5% on Friday, and I'm sorry... I've just got to make fun of it. But first, here's a little story I once heard that you won't find on Intel's website.

Way back in the mists of history when IBM was looking for a company to provide processors for the original IBM PC, it approached Motorola first, and was turned down. Motorola's 68k was a great processor, and Apple would later build a very popular computer (the Macintosh) around it. But IBM wanted to order a ton of chips, far more than Motorola felt it could produce. Motorola's yields on the 68k chips just weren't very high, and they felt that building more and bigger manufacturing facilities would just create problems.

So IBM turned to a small, hungry company with a less desirable design: Intel and the 8086 CPU. To produce the required number of processors to run all the PCs IBM intended to sell, Intel came up with a stripped down version of the 8086, a new design that they christened the "8088." The 8088 could best be described as "a brilliant piece of absolute rubbish." And it was. It was a slow, primitive chip, but it ran the same software as Intel's mediocre 8086 chip. And it was dirt cheap to make. Best of all, Intel could crank the suckers out by the boatload. Intel got the IBM contract and subsequent contracts for the IBM XT and AT, and the rest is history.

The moral, of course, is "If you can build it -- and a lot of it -- they will come." (Sorry, couldn't resist.)

The real moral is that Intel got the original PC microprocessor contract through skill at mass manufacturing, not at design. In fact, its primary strength today is still manufacturing. Intel has higher yields than its competitors, giving it more useable chips per wafer burned, and thus a lower cost per chip. So even when it sells its product for less than the competition, it can still turn a greater profit. It saves on manufacturing costs per chip and it simply has more chips to sell. Sales volume and profits are greater than the competition.

Which brings us back to Mr. Kurlak and his quarterly (or is it monthly... weekly?) Intel stock price prediction. What sparked his latest downgrade?

Intel's recent analyst-frightening move was to upgrade its microprocessor fabrication facilities in New Mexico, Arizona, and now Ireland to 0.25 micron technology. That means that the wires in the chips are a quarter of a micron wide, which is, as they say in the industry, "very very small. Extremely small." Smaller chips are naturally faster, because a signal takes less time to travel down shorter wires. Smaller chips also take up less space on a silicon wafer, meaning the new process can fit more chips on each wafer for roughly the same price per wafer as the old process. Producing more chips for the same price results in a lower cost per chip, and is thus a good thing, right?

Not according to Wall Street.

Merrill Lynch's Thomas Kurlak finally noticed that Intel is in a position to outright flood the market with cheap high-end CPUs. Kurlak announced that the increase in chip supply was almost certain to lower prices and eat into Intel's gross margin. In response, Intel stock finished down over 5% on Friday. In the short term, he's probably right, and Intel knows it. Intel has delayed a new fab in Texas and laid off 3000 workers to preemptively reduce costs. Intel just doesn't need all the production capacity it has right now, let alone even more capacity.

In the short term, an oversupply of chips in the market will almost certainly drive down the price. Whether this will result in lower near-term profits for Intel is an open question. Quite possibly, Intel will make up the difference by selling more chips at lower manufacturing costs. Regardless, I'm glad that my investment in Intel is not just for the short term. I wonder what sort of investment approach Mr. Kurlak is promoting with his series of downgrades and upgrades in months and years past.

In the long term, Intel is in great shape. I have to believe that Kurlak agrees. The company has lower costs than its competitors. It can afford to sell for less and still make a profit. Net margins at Intel are sitting above 25% today on more than $24 billion in trailing sales. This while costs are falling.

And due to Intel's lower costs, the clone chipmakers are barely staying afloat. National Semiconductor (NYSE: NSM) -- the parent company of rival chipmaker Cyrix -- has seen its margins gutted over the past year while enduring a stock drop from $42 to $17. The company announced Friday that, over the next two quarters, it will lose even more money than expected. And Advanced Micro Devices (NYSE: AMD) has lost $700 million over the past four years while seeing its debt recently downgraded to "junk bond" status. AMD recently borrowed another $500 million to stay afloat. Its stock price has fallen from $43 to $23 in the past year.

All very bad news for Intel, eh?

Now, both Cyrix and AMD have excellent microchip designs. Yes, they do. But neither company has the manufacturing capacity to compete with Intel. Thus, Intel swallows up the heavy volume sales and can defend its 50% gross margins. Our company has much better yields, leading to lower costs. The result? Intel can price its competitors out of the market literally any time it chooses. It just prefers, given the option, to make more money. Call me a Fool, but I just don't see how improvements in Intel's manufacturing processes are supposed to be a bad thing for anyone but Intel's competitors.

There may be a short-term profit lag as our giant manages overall capacity, but can Tom Kurlak possibly think that Intel is meaningfully threatened in the long term? And if he agrees that Intel is in good position to be a long-term market beater, given that the majority of Merrill Lynch's clients should be long-term investors... shouldn't that be a core portion of his message? It would've served him well in years past. Over the past decade, Intel has rewarded shareowners that don't respond to short-term ratings changes with a stock price ascension from $2 to $80.

So I believe that Intel stock continues to be a bargain here, and I continue to send in regular monthly contributions through my Dividend Reinvestment Plan. If you're interested in setting one of those up yourself, check out the DRIP discussion folder right here at the Fool, or the DRIP portfolio, which co-incidentally also has Intel among its holdings. There's also a message folder devoted to Intel, and it's also a topic in the Cash-King folder as well.

- Rob Landley

P.S: And hey, don't take my word for any of the above. You can read about it yourself at:

1. AMD announces plans to borrow $400 million
2. AMD starts to borrow $450 million
3. AMD finishes borrowing $517.5 million
4. National Semiconductor press release about losing money
5. Kurlak warns about CPU glut


Stock  Change    Bid 
 CHV   -  1/2   82.19 
 KO    +  5/8   78.06 
 GPS   -  1/16  52.88 
 EK    -  1/4   70.25 
 XON   -  1/4   72.31 
 GM    -  15/16 72.69 
 INTC  +  1/4   79.56 
 MSFT  +  7/16  86.44 
 PFE   +2 1/8   112.81 
 TROW  +  7/16  35.81 
                  Day   Month    Year  History 
         C-K      +0.32%  -0.40%   8.03%   8.03% 
         S&P:     +0.33%  -0.20%  10.81%  10.81% 
         NASDAQ:  +0.78%  -1.21%  11.68%  11.68% 
 Cash-King Stocks 
     Rec'd    #  Security     In At       Now    Change 
     2/3/98   22 Pfizer        82.30    112.81    37.08% 
    2/27/98   27 Coca-Cola     69.11     78.06    12.96% 
     2/3/98   24 Microsoft     78.27     86.44    10.44% 
     2/6/98   56 T. Rowe Pr    33.67     35.81     6.35% 
     5/1/98   37 Gap Inc.      51.09     52.88     3.49% 
    2/13/98   22 Intel         84.67     79.56    -6.04% 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Exxon         64.34     72.31    12.40% 
    3/12/98   20 Eastman Ko    63.15     70.25    11.25% 
    3/12/98   17 General Mo    72.41     72.69     0.39% 
    3/12/98   15 Chevron       83.34     82.19    -1.39% 
 Cash-King Stocks 
     Rec'd    #  Security     In At     Value    Change 
     2/3/98   22 Pfizer      1810.58   2481.88   $671.30 
    2/27/98   27 Coca-Cola   1865.89   2107.69   $241.80 
     2/3/98   24 Microsoft   1878.45   2074.50   $196.05 
     2/6/98   56 T. Rowe Pr  1885.70   2005.50   $119.80 
     5/1/98   37 Gap Inc.    1890.33   1956.38    $66.05 
    2/13/98   22 Intel       1862.83   1750.38  -$112.46 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Exxon       1286.70   1446.25   $159.55 
    3/12/98   20 Eastman Ko  1262.95   1405.00   $142.05 
    3/12/98   17 General Mo  1230.89   1235.69     $4.80 
    3/12/98   15 Chevron     1250.14   1232.81   -$17.33 
                               CASH   $3910.83 
                              TOTAL  $21606.89 
 *The year for the S&P and Nasdaq will be as of 02/03/98