Chip giant Intel (NASDAQ:INTC) is a type of company that's commonly referred to as an integrated device manufacturer, or IDM for short. This means the company both designs chips and manufactures those chips. Most chip companies aren't IDMs but are instead what are referred to as fabless semiconductor companies -- a fitting name since a chip manufacturing facility is often referred to as a "fab," which is short for "fabrication plant." These companies produce their own chip designs, but they rely on third parties, known as foundries, to manufacture them.

The reason most chip companies are fabless is that owning and operating chip manufacturing plants is incredibly expensive. It costs billions to build and equip a chip factory, and it costs billions more to develop the know-how, known as a process recipe, to put that equipment to good use building chips.

A wafer of Intel processors.

Image source: Intel.

Each year, Intel spends billions of dollars in capital expenditures, or capex for short, to support the production of the hundreds of millions of chips it builds each year. The amount the company spends on capex varies from year to year.

Going into 2018, Intel had told investors that it expects its total capital expenditures to come in at $14 billion for the year. However, on its earnings conference call on April 26, the company raised that expectation by $500 million. Intel's looking at a whopping $14.5 billion in capex for 2018.

Let's go into why Intel raised its planned capex for the year and what this means for the business.

Higher capex to support greater demand

Chip companies' capex needs are typically dominated by the amount they spend on the highly expensive equipment that's used to produce chips. A single tool used in a chip manufacturing plant can easily cost hundreds of millions of dollars, and as those tools become more complex in nature, those costs rise.

During Intel's most recent earnings conference call, company CFO Bob Swan explained that the company's increased capex for the year is due to the fact that the company is seeing better-than-expected demand for its chips this year. (Intel raised its revenue guidance for 2018 by $2.5 billion, which suggests a solid increase in expected chip shipments.)

Don't think that because Intel is seeing better demand for chips this year that it's just going to spend a little more this quarter and have more production capacity in place next quarter -- it doesn't work like that. It usually takes multiple quarters for a chip company to acquire and install chip production tools and to get them up and running.

What we're seeing, then, is that because Intel is seeing better demand for chips today, the company now expects to sell more chips in the future. Since Intel doesn't want to end up falling short of its new demand projections, say, a year or more out, it's buying more equipment to boost its production capacity now.

The financial impact

For 2018, the financial impact to Intel from this increased capex is fairly minimal. The company has to spend an additional $500 million on capital equipment, which will reduce free cash flow by $500 million, but since the company's revenue is substantially higher, it more than makes up for the additional capex. Intel is guiding to a $1.5 billion increase in its expected free cash flow for 2018 compared to its prior outlook, net of the increase in capex.

Over the long term, the capex Intel spends today will show up in the company's financial results in the form of depreciation expenses. The way this works is that Intel spends a bunch of money on a chip manufacturing tool today, but until that tool is installed and being used to crank out chips, it doesn't show up in the company's financial results. Once the tool is up and running, Intel spreads out the cost of that tool over some fixed period of time -- the length of time the company expects that tool to be useful.

If Intel can keep that equipment busy -- that is, its chip manufacturing plants have high utilization rates -- then that cost gets spread out over a larger number of chips, lowering the company's effective cost per chip. However, if Intel misjudged future demand based on the strength it's seeing today, then it could find itself with underutilized factories. Since that same equipment is being used to produce a smaller number of chips, fewer chips absorb the costs of that equipment, negatively impacting the company's gross profit margins.

In a nutshell, Intel's betting that because demand for its products are proving to be greater than expected, it needs to put in more capacity to support what it expects to be greater future demand for its chips. Intel has been pretty good about calling demand in recent years (if anything, it has been too conservative), so if you're an Intel stockholder, don't fret about this capex increase -- it's probably going to prove to be a good thing for the business. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.