Drip
Portfolio Report
Tuesday, February 17, 1998
by Jeff Fischer
([email protected])
CHICAGO, IL (Feb. 17, 1998) -- A majority of homes in the world and in the United States still do not own personal computers. So after nearly two decades of PC development, it seems appropriate that price points are finally declining to a level where a greater number of families will be able to afford a PC -- especially in the next five to ten years.
With lower prices should come much higher sales volume for companies in the PC industry. But in the CPU market specifically, sales volume is only an advantage to a consistently profitable company, one that can ramp up production of new microprocessors quickly and efficiently enough to meet demand while maintaining healthy margins. Though the sub-$1000 PC market was launched by Compaq Computer (NYSE: CPQ) based on a Cyrix chip -- of parent company National Semiconductor (NYSE: NSM) -- Intel already leads in market share for the inexpensive PC segment, and Intel was able to maintain gross margins of 59% in the fourth quarter.
Last week an analyst downgraded Intel (Nasdaq: INTC) while citing a fear that customers were demanding lower prices, thus threatening to decrease Intel's profits. Although the analyst's report wasn't made public, hopefully it was concerned about the business segment of the PC market rather than the consumer end. Why? If low-end computers make sense to home PC buyers, they should make sense to much of corporate America as well, meaning that Intel might sell fewer high-end machines all around. In a recent interview, IBM (NYSE: IBM) executives said that only 20% of its employees were likely to need powerful machines, while 80% could get by on low-end PCs. But (for a full circle), recent reports actually show that low-end sales have not cannibalized higher-margin machine sales as was first expected.
Now you have two camps:
- Low-end sales will hurt high-end sales on all levels and decrease profits (the camp of the analyst in question, or so we surmise).
- Low-end sales are an opportunity.
Much more important than choosing a "camp" is knowing your company and how it works.
At the same time that a Merrill Lynch analyst downgraded Intel, two other firms -- Prudential Securities and Donaldson, Lufkin & Jenrette Securities -- upgraded or initiated coverage of the stock with "buy" ratings.
Why?
In part, because the fourth quarter was stronger than expected and the new low-end PC market is seen as an opportunity, one that Intel is in a position to dominate. How? Most interesting to remember, especially now, is this: What made it possible for Intel to lower prices and increase margins over the past ten years was not "a struggle with customers" (as a Merrill Lynch analyst suggests is cursing the company now), but a business model that feeds itself by generating ever more efficient returns even as the prices that Intel charges per generation of CPU declines -- as per Intel's plan.
From that foundation, there are several factors to consider when thinking about Intel's business. Let's run through some of them.
Gross Margins. An analyst may voice concern over declining gross margins as a result of product mix (more lower-end PCs being sold, for example), but that concern is already public knowledge. Intel has stated for the past several quarters that margins will decline, though gross margins have stayed in the high 50s. But eventually they should decline to the low 50s. Investors already know this. Will it really happen? So far, Intel's margins have remained higher than the company willingly predicts. But why might Intel continue to perform well, no matter where margins finally land, give or take a few points?
Increased efficiency. The manufacturing of microprocessors is an art, one that is moving towards the "extreme miniature" with every new generation of chip. The more chips that can be fit onto a wafer, the less it costs to produce a chip. Beginning in late 1997, Intel began to move towards 0.25 micron geometry, migrating away from the current 0.35 micron. (The migration of the industry from 0.35 to 0.25 micron on eight-inch fabs is feeding the fire of semiconductor equipment stocks.)
Using 0.25 micron, it's estimated that Intel can produce around 200 Pentium II chips per wafer, up from an estimated 125 chips that the company is thought to produce currently on 0.35 micron. This projected 60% increase in productivity will cut costs substantially for each chip produced, helping Intel to maintain margins while still being able to pass savings onto consumers. The company won't be completely switched over to 0.25 micron until probably the end of the year, though it is ramping up quickly.
Product mix. The fear is that low-end cheap-as-the-dickens chips that even grandpa could have produced out in the chicken coop during the early 1900s will swamp the market and drive margins down. Actually, the highest-end Pentium II chip is Intel's fastest growing product. Climbing from about 25% of Intel's microprocessor output in 1997, the high-end Pentium II should account for about 50% of total microprocessor output at Intel by the middle of this year.
Total Market. In a nutshell, lower PC prices should expand the total PC market. And what is Intel involved in? The total PC market, from networking to Flash memory.
More tomorrow. Be Foolish!
-- Jeff Fischer
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