After the market closed last night, Intel (Nasdaq: INTC) released its first quarter earnings. The initial reaction to what appeared to be solid numbers was negative, as the stock traded down in after-hours trading. While I grant you that what happens in after hours is relatively meaningless to me, I'm writing this article late Tuesday night and my curiosity is high enough that I wanted to try and gauge the reaction of the Wise to the report.
As expected, some members of the Wise community are concerned about the contribution of Intel Capital to the bottom line. Based upon my understanding of how Intel Capital works, I don't worry too much about the level of its contribution to Intel's profits. To me, these are strategic investments that allow Intel to enhance its ability to sell more of its products and compete in the marketplace. As a matter of fact, this is something that at least to a certain extent is expected of Rule Making companies. After all, these are companies that generate oodles of cash from their operations, so I find nothing wrong with them benefiting from their strong cash position. Of course, I also realize, that erratic market behavior could make this number turn south in the future as well.
As shown in the updated Rule Maker Ranker I posted for Intel before writing this column, Intel still scores as a Top Tier Maker with a score of 51. This number is a decline from last quarter's mark, but it's still a top mark. We'll discuss these numbers more a bit later, but there's one thing that I do find troubling about the report that I'd like to address first.
At this point in time Intel only really has one significant competitor -- Advanced Micro Devices (NYSE: AMD). Financially, Intel is much stronger than AMD, which is why it nabs 18 of the 20 available Monopoly Status points on the Ranker. Over the last couple of years, Intel has been making heavy investments outside of its core microprocessor business, which is a strategy that I support. However, I can't help but think that it's dropped the ball at least a little bit in terms of investing enough to keep its microprocessor business up to snuff.
Capital should never be a constraint for Intel's operations. Yet, in the conference call Intel said that customer demand continued to outstrip supply during the first quarter. This problem is expected to continue in the second quarter as well. Intel does expect that this problem will be cleared up by the time the third quarter rolls around.
Allocating money for chip fabrication plants is not an easy call. If a company overestimates demand, it can end up with idle capacity at its plants. Due to the way that fixed costs for operating the plant are allocated, this error in judgment can easily lead to lower gross margins and, consequently, lower net margins, as well. On the other hand, it's possible that underestimating demand can force customers to look to other suppliers for the products they need. If these alternate suppliers (i.e., AMD) are able to provide quality products, it's possible that those customers (i.e., Dell and Gateway) could move more of their business to that supplier in the future.
Intel said the key factors that have led to demand being higher than anticipated are the recovery of the worldwide economy (Asia Pacific and Japan, in particular) as well as the significant role the Internet has had in driving demand at a faster-than-anticipated pace. I do have to admit that I find this last statement a bit puzzling because Intel, of all companies, has been on top of the Internet's significance for some time. Chairman Andy Grove is noted for having said, "There will be no Internet companies in the future, only those that use the Internet and those that have been crushed by competitors who do."
Don't get me wrong here. I'm not saying that AMD is going to usurp Intel's position at the top of the food chain anytime soon. (I suspect that there are a few AMD fans out there that will send me some flame mail for saying that, but that's my take.) It was clear from the call that Intel is not happy with having underestimated demand, and they clearly are addressing the situation.
In addition, during the call, Paul Otellini, manager of the Intel Architecture Business Group, made a number of comments indicating that Intel is not losing its existing market share to AMD. He said that Intel's share of the market was essentially unchanged from the fourth quarter (which was up from the third quarter). He also said that he is very pleased with Intel's existing product portfolio, and that Intel is "as strong today as [it's] ever been and that, over the course of the year, that will only get stronger."
Based on these comments, it appears that AMD has taken a bigger piece of the market share that was previously served by some of Intel's former competitors like National Semiconductor (NYSE: NSM), which exited the microprocessor market during 1999. Even so, Intel's market share has been relatively unscathed, and it is making the necessary steps to improve this situation.
How will it get stronger? First of all, Intel has been upgrading five of its fabs from 0.25 micron to 0.18 micron manufacturing technology. It's also expecting to bring three new fabs on-line (including one acquired from Rockwell). By the end of the second quarter more than 50% of Intel's chips should be produced using the 0.18 manufacturing process, and this figure should be up to 90% by year-end.
Intel also has significantly increased its investment in research and development (R&D). During the quarter, R&D spending grew more than three times faster than sales. Intel's R&D investment is focused on 0.13 micron technology as well as the conversion to 300 mm wafers, which should increase its chip yield and reduce manufacturing costs significantly. Intel's ever-increasing manufacturing efficiency should serve it particularly well in its efforts to better meet demand in the future.
I'd like to spend the rest of the report by taking a brief look at Intel's Rule Maker numbers for the quarter.
- Sales Growth of at least 10% -- During the quarter, Intel grew sales by 13% over the year ago figure. Based upon the information provided in the conference call, I expect that it will continue to meet our target of 10% year-over-year growth at least through the rest of the year. The two key business segments for Intel right now are microprocessors and flash memory chips (which primarily go into cell phones). Intel's network communications group also recorded record revenue for the quarter. Average selling prices were about even for the quarter, but it wouldn't be surprising to see them fall later in the year as Intel ramps up production a bit and as overall supply is better able to meet demand.
- Gross Margin of at least 50% -- Intel's gross margins for the quarter scored a solid 63%, up nicely from 59% a year ago, as well as up from last quarter's 61%. Guidance for the year is that gross margin will be 61% plus or minus a couple of points. That's definitely Rule Maker territory and significantly higher than AMD's results.
- Net Margin of at least 7% -- During the quarter, Intel reported a one-time income tax benefit of $600 million. When I calculated Intel's net margin, I reduced its pro forma income by this amount to $2,474 million. This resulted in net margin of 30.8%, which was an increase over the 28.4% recorded a year ago.
- Cash-to-Debt ratio of at least 1.5 -- Intel has $11,216 million of cash and equivalents, $373 million of short-term debt, and $868 million of long-term debt. That gives it a ratio of 9x more cash than debt. This is a strong result, though it is down from the year ago figure of 12x. Intel's business continues to throw off significant cash. Unfortunately, we can't check the Cash-King Margin until Intel's 10-Q is released next month.
- Flow Ratio of less than 1.25 -- Intel's Flow Ratio fell to an impressive 0.93, a slight decrease from the year ago figure of 0.97. There is a possibility that this number could increase slightly later in the year, as Intel would ultimately like to replenish its inventory levels a bit.
All in all, if you're an investor with a focus on the long-term, while there are a couple of things to keep a watchful eye on, this was another solid quarter for Intel. The company continues to look good when run though our investment criteria.
Phil Weiss (TMFGrape on the boards)