More Thoughts on Intel
Who's right, Jeff or the media?

by Brian Graney (TMFPanic)

ALEXANDRIA, VA (May 6, 1999) -- Yesterday, Jeff offered his impressions of National Semiconductor's (NYSE: NSM) farewell to the CPU market and how that news affects portfolio holding Intel (Nasdaq: INTC). This development probably warrants at least two days' worth of attention from us since it comes on the heels of Intel's recent unveiling of its "grand Internet strategy," which is intended to transition the company from a chipmaker to a full-fledged networking company. Also, I hate letting Jeff have the last word on anything.

Jeff takes exception to journalists describing conditions in the PC chip business as "cut-throat" or "brutal" or "knock-down drag-out blood-on-the-streets hard." However, the exaggerations may not be as great as my Drip Port amigo thinks, especially in respect to the low-margin sub-$1,000 PC market where Intel and National Semiconductor competed against each other last year.

It's no secret that Intel is using the cash rolling in from its dominance of the high-end server and workstation processor market to more or less subsidize a major assault on the low-end PC market, with price decreases as its preferred weapon of choice. Management has practically admitted as much. Unfortunately for its low-end competitors, though, only Intel is in a position to play the game this way. National Semiconductor's move yesterday underscored this fact, leaving Advanced Micro Devices (NYSE: AMD) alone to bear the brunt of Intel's enormous financial edge in the low-end business.

The profit advantages of high-end chips versus low-end chips is substantial and can be backed up with data. According to numbers reported in an International Data Corp. report last January, Intel garnered an 80% unit share of the total microprocessor market last year, but gobbled up a higher (92%) relative share of the market's $22.4 billion in revenues. AMD, on the other hand, accounted for a 12% unit share of the market but a much lower (5.6%) relative share of the market's revenues. Ditto National Semiconductor, whose 4% share of the market in terms of units converted into only 1.4% of the market's revenues.

What does this statistical gibberish mean? In English, Intel's high margin, high-end products allow the company to convert every percentage point gain in unit market share into a 1.15 point gain in revenue market share because its high-end products are not subject to price competition. On the flip side, a one percentage point unit share gain by the low-end PC chip makers only translated into a mere half percentage point gain in revenue share because of price competition. Of course, some of this discrepancy can be attributed to Intel's stunningly efficient manufacturing and execution processes, but the existence of price competition in the low-end but not the high-end should be properly considered here.

As National Semiconductor made clear yesterday, the entry of Intel and its Celeron chip into the low-end CPU business last year sucked the cash lifeblood out of the company. "Not believing Intel would come after us in the low-end space was a mistake," National Semiconductor chairman, president, and CEO Brian Halla reportedly told analysts on a conference call yesterday. Talk about an understatement.

Over the past few quarters, it has become evident that Intel's year-old low-end strategy is doing similar damage to AMD, since AMD has limited resources at its disposal to turn the tables and get into the higher margin business areas where Intel dominates. It's stuck in the low end and it's paying for it. AMD's average selling prices for its chips dropped to about $78 in Q1, down from around $89 during the previous quarter and about $100 in the quarter before that. In turn, margins are eroding like a sand castle being slowly washed away by an incoming tide, falling to 29% last quarter from 39% in Q4 and Q3.

The comparably lower margins and price competition of the low-end CPU business are starting to show up in Intel's margins as well. While Intel's margins may not be sliding on a percentage basis as much as AMD's margins, they are sliding nonetheless. Overall, gross margins are still in the mid-50% range, but that does not belie the fact that operating margins at the core Intel Architecture Business Group fell to 42% in 1998 from 51% the year before. That decline can be fully attributed to Intel's push into the sub-$1,000 PC market with the Celeron and the how-low-can-you-go pricing strategy that went hand-in-hand with the product's launch.

So, if the low-end CPU business does not qualify as cut-throat given the current conditions and last year's data, what does? Jeff cited the disk drive industry as one cut-throat sector, where unit shipments increase year-over-year as ASPs spiral downward. But I don't think that is an appropriate comparison since none of the major disk drive companies have a high-margin, high-moated, cash cow business in their arsenal like Intel does in the processor business.

Just is a hypothesis, consider what would happen if a high margin, high end data storage company such as EMC (NYSE: EMC) had the determination and the appropriate existing know-how and assets in place to make a serious run at the low end data storage market. Wouldn't the industry become more cut-throat, up until the point where EMC's substantial financial advantages run many of the major disk drive players either out of the industry or into bankruptcy court?

(That's a hypothetical question, of course. Don't expect EMC to prove it right or wrong through experimentation.)

So, I think the low-end CPU business may just be as cut-throat as the press makes it out to be, while Jeff probably thinks I'm nuts. That's okay, though. Our difference in opinion notwithstanding, Jeff and I still agree that Intel is a great place to stash this portfolio's money on a regular basis over the next twenty years. But with the changes going on in the chip business right now, we need to re-evaluate how we think about Intel's business going forward. Intel has already made this switch; our job as shareholders and business analysts is to figure out what it all means.

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