Intel: The Times They Are a Changin'

Tonight, I thought I'd check in on our best-performing stock so far this year, Intel Corporation (Nasdaq: INTC), which is up close to 50% year-to-date. The increase in its stock price has made our chipmaking giant the fourth public company to surpass $400 billion in total market capitalization. As an investor that focuses primarily on the long-term, and as one who also enjoys learning about and understanding great businesses, I'm much more interested in the ways that Intel's business is changing than I am in the short-term movement of its stock price. So, let's take a look at how Intel's business has been changing over the last year or so.

Back in the early '80s, Intel hit what former CEO Andy Grove has coined an inflection point. Due to the dominance of the Japanese in the memory chip industry, Intel decided to massively overhaul its business focus as it quit making memory chips altogether and redirected its considerable resources towards microprocessors. That move was something of a gamble for Intel as the microprocessor market was far from developed at the time. It was, however, a move that paid off quite handsomely, as it led to Intel's leading role in setting the pace for global PC development.

Now, once again, Intel is trying to reshape itself. Under the guidance of its current CEO, Craig Barrett, Intel is attempting to become a supplier of a multitude of silicon-based products that can be used in new product lines that include networking gear and information appliances, in addition to its traditional base within powerful PCs. Our company is also now selling into such markets as e-commerce, wireless phones, consumer electronics, and Internet servers.

First let's take a brief look at the microprocessors that are currently in the pipeline:

IA-64 (Itanium) Server Architecture -- Formerly called Merced, this chip architecture is expected to be released in the second half of this year. It's expected that the first processors will run at 733 MHz and 800 MHz. McKinley is the code name for the second-generation IA-64 processor, which is expected to be released next year.

IA-32 (Willamette) Architecture -- This is Intel's next-generation processor for the desktop. At its recent developer forum, Intel demonstrated a version of Willamette running at a clock speed of 1.5 GHz. Intel's belief is that this processor will power those PCs that are linked to the Web via a broadband connection.

Timna -- This is expected to be the next generation replacement for Intel's Celeron chip, which is sold to the low end of the market.

Servers are the real big-money item for Intel. According to MicroDesign Resources, Intel's current server chip, the Xeon, represents about 15% of its processor revenues even though it only accounts for 4% of the units sold. The Itanium chip, and even more importantly, the McKinley chip are expected to drive Intel's advances into the server market.

Intel is clearly getting more of a run for its money in the microprocessor space as Advanced Micro Devices (NYSE: AMD) and Intel have been in a race to provide the fastest available chips to the marketplace. Despite AMD's efforts in this area, Intel continues to hold a dominant share of the market. This is primarily due to a couple of key factors. One is that its manufacturing efforts are much more efficient. This leads to higher chip yields as well as higher gross margins. When both companies cut their prices, Intel is hurt less as its operation is run much more efficiently. Intel also has more fabs producing its chips than AMD.

Right now, demand is so strong that Intel is actually having trouble meeting it. The upshot of this is that it helps keep chip prices more stable. The downside is that there is always a danger when you give your competition an opportunity to sell more products. While original equipment manufacturers (OEMs) could increase their demand for AMD chips, Intel is helped by the fact that many end-users prefer Intel chips to AMD chips because of their brand-name recognition as well as their reliability.

In 1999, between $25 and $30 billion in microprocessors were sold. It is estimated that this market will have sales in excess of $40 billion in 2002.

Intel now has five product groups. Computer Processors, which we just discussed, is one. Here's a little bit about the rest:

Network Chips -- It is Intel's belief that its Internet Exchange Architecture (IXA) and its software programmable building blocks will provide a better way to design networking equipment. Intel believes that by providing as much programmability as possible, IXA will be able to speed and simplify the design of new networking gear. This family of 13 chips was rolled out last September. Intel's Network Communications group also sells chips used in modems, network interface cards, switches, and routers. The networking chips business was a little more than a $4 billion market in 1998. Estimates are that it will be an $8-$10 billion market by 2002.

Communication Products -- Intel is starting its communications push with initiatives in the home and small offices. Broadband access will be the major driver of home networking. Its overall lineup of products includes Ethernet hubs, small networking switches, and routers. Intel also has a line of specialized servers that manage Web traffic and speed up e-commerce. It also sells PC-based phone systems. Recent figures show that this market had sales of $20 billion in 1999; it is estimated that sales in 2002 will be $30 billion.

New Businesses -- There's not yet a lot of information about the types of projects that Intel is working on in this division. The one that has received the most press so far is Intel's Web-hosting business. The first of its centers is up and running in Santa Clara, California. At present, Web-hosting revenues are less than $2 billion. It's estimated that they will be $9 billion in 2002. But, right now Intel is a bit behind in this market. The current leaders, IBM (NYSE: IBM) and Exodus (Nasdaq: EXDS), have 30% of the market. Among the other products currently being worked on are a digital handheld health planner that links to a PC and a website.

Information Appliances -- Intel hasn't shipped any products for this business area yet. The key move it has made so far was its $1.6 billion acquisition last fall of DSP Communications. It has also made an aggressive move to sell chips for wireless phones. Possible products include screen phones, e-mail terminals and TV set-top boxes. It is expected that the majority of these products will use Celeron chips and Linux software. They will be sold through phone companies and Internet Service Providers. The StrongArm II is Intel's answer for the handheld market. This chip, which is expected to run at a clock speed of about 400 MHz at extremely low power, should ship during the second half of this year. It's expected that by 2002 the market for information appliances will be larger than the consumer PC market.

So, what is it that's driving all this change at Intel? It's really two things. One is that it wants to drive its future growth by entering some new markets that are growing more rapidly than the microprocessor market, and each of the markets above is growing significantly faster than Intel's core microprocessor market. The other is that while the PC was the center of computing during the '90s, Barrett expects that the Internet will assume this role over the next decade. This has led to a change in Intel's mission statement as well. Our company now aims "to be the preeminent building block supplier to the worldwide Internet economy."

Intel certainly hasn't given up on microprocessors, though. Much of its business is built around servers, which are gatekeepers for Web access, e-mail, and local area networks. Servers will be the building block for a variety of its Internet services. While Intel's servers may not currently be able to satisfy the performance requirements of e-commerce, the company does realize that what Barrett calls "big hulking servers" are needed to fuel the new economy. As a result, over the past two years, 50% of Intel's research and development (R&D) investment has been spent on microprocessor research. The big push is expected to start when the first Itanium processors are shipped.

There's one other initiative that Intel has made that has added to its bottom line -- its investment portfolio. As a Rule Maker, Intel has a large stable of cash. It's effectively deploying that cash to expanding its core business and developing new businesses. It's also using that cash to make a number of successful investments. Led by head of corporate investments, Leslie Valdasz, Intel Capital had a portfolio of 350 companies valued at $8.2 billion at the end of 1999, compared with just 50 companies worth $500 million two years earlier.

Investments sold by Intel in the last quarter added about $0.03 to its earnings per share. Currently, it has nearly $6 billion in unrealized gains. Some view this as a negative. Not I. Intel's investments provide it with two significant benefits. First, Intel's strategic investments offer it an insider view into new technologies that could enhance Intel's own R&D efforts and growth possibilities. Second, Intel's equity investments offer a way of multiplying spare cash at levels well in excess of what could be earned while sitting in the bank. As an investor, I am pleased to see my company deploying its cash in this manner.

These are clearly dynamic and changing times for Intel. I have confidence in the management team to execute its strategy. Based on the recent progression of its stock price, it seems that much of the market does as well.

Phil (TMFGrape on the boards)

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