On Sept. 16, microprocessor giant Intel (NASDAQ:INTC) announced an upward revision to the financial guidance that it provided back in July. The company says that it now expects revenue of $15.6 billion for its third quarter (give or take $300 million), up from a prior forecast of $14.9 billion (plus or minus $500 million), as a result of "replenishment of PC supply chain inventory".
Intel said that in addition to the inventory dynamics, it is "also seeing some signs of improving [personal computer] demand".
The good news expands beyond revenue as well. The company is raising its gross profit margin guidance from 60% to 62%. Intel attributes this improvement mainly to "higher PC unit volume". And finally, the company says that its operating expenses will now come in at "approximately $5.2 billion", a slight increase from previous guidance of $5.1 billion.
Let's take a closer look at what's going on here.
PC inventories apparently lighter than expected
Intel doesn't sell personal computers directly to consumers. Instead, it sells key components (mainly processors) to personal computer vendors. Those vendors then take these components and integrate them into complete systems that are sold to end users.
Those vendors need to keep inventories of both components as well as completed systems in order to be able to satisfy customer orders in a timely fashion. For example, if Joe Public goes to the Dell website and places an order for a new system, Dell needs to already have the components around to build the system that Joe ordered.
Those system vendors need to make their "best guesses" as to the kind of demand that they will see for personal computers -- those demand forecasts almost certainly inform Intel's production and sales plans, which is how the chip giant is able to provide reasonably solid quarterly sales guidance to investors.
What appears to be going on here is that the personal computer vendors found themselves with lower inventory levels of components/personal computers than they would like. As a result, they have seemingly ordered more processors from the chipmaker in a bid to bring their own inventory levels up to better support the demand that they expect for their products.
Why is margin guidance up?
In addition to the better-than-expected PC processor sales, Intel also guided gross profit margins up, which obviously helps to amplify the profit growth that higher revenues at flat margins would have brought.
Intel attributes the margin increase to higher personal computer chip sales volumes. One point that might be a little confusing to some is why margins would actually go up with revenue, but it's not too hard to understand.
Remember that Intel owns and operates its own chip manufacturing factories and that the vast majority of the chips that the company produces are targeted at personal computers. To build and equip these factories, Intel needs to make significant capital investments.
The cost of these factories flows through to Intel's financial results in the form of depreciation. The depreciation essentially shows up as part cost of goods sold, or COGS. Recall that gross profit margin percentage is calculated by dividing gross profit (which itself is calculated by subtracting COGS from net revenue) by total revenue.
The depreciation costs that Intel incurs in a given quarter are essentially fixed, and that cost is spread out across the number of chips that the company ships in a given quarter. They're also a significant portion of Intel's total cost of sales, as the slide below illustrates:
If Intel is able to ship more chips than it had previously expected, then that depreciation cost is spread out over a greater number of units. This means that the effective cost to manufacture each chip is lower, leading to better gross profit margins.
Ashraf Eassa owns shares of Intel. The Motley Fool recommends Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.