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Inside Intel's Big Sacrifice

By Ashraf Eassa - Nov 1, 2018 at 7:51AM

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The chip giant had to make some tough choices amid capacity constraints.

Ahead of Intel's (INTC -2.86%) Oct. 25 earnings release, reports emerged suggesting that the company was struggling to meet demand for its products.

That chorus of reports seemingly pushed Intel to issue a supply update on Sept. 28 in which the chip giant admitted that "supply is undoubtedly tight, particularly at the entry-level of the PC market." At the time, the company also said that it was "prioritizing the production of Intel Xeon and Intel Core processors so that collectively we can serve the high-performance segments of the market."

When Intel announced results for its third quarter, it blew away its own and analysts' expectations. And once again, the company lifted its full-year outlook, this time to $71.2 billion from $69.5 billion. What's interesting, though, is that even though Intel interim CEO and CFO Bob Swan said that the company will "have supply to support this revised guidance thanks to the outstanding responsiveness from our factory teams," the company will still not be able to meet all the demand for its chips in the fourth quarter of 2018.

Intel Xeon Scalable processors.

Image source: Intel.

In this situation, Intel is making some interesting trade-offs that investors should understand. Let's take a look. 

Sacrificing low-end PC and the Internet of Things

Swan said that in this situation, Intel's "focus has been prioritizing, in conjunction with our customers, Xeon and Core processors," echoing what it said in its Sept. 28 supply update.

That, Swan explained, means that "by definition, the lower end of PC and the [Internet of Things] business is being constrained."

In fact, Swan said that as a result of this supply situation, Intel's Internet of Things Group (IoTG) -- which made up about 4.8% of Intel's sales and grew 8% on a year-over-year basis last quarter -- is set to see revenue decline by 15% in the fourth quarter versus third-quarter levels. This should translate into sales of around $781 million for a year-over-year decline of around 11%, although investors should keep in mind that in the fourth quarter of 2017, Intel's IoTG included revenue from its now-divested Wind River business

It's not hard to understand why the company would choose to make that trade-off. In a situation where demand for the company's silicon exceeds supply, it makes sense for it to try to maximize the amount of revenue that it can generate for each square millimeter of the silicon that it produces.

Intel's Xeon data center chips as well as its Core family of personal computer chips tend to carry higher average selling prices than its lower-end Pentium and Celeron personal computer processors. I'd also wager that Core and Xeon average selling prices are greater than a significant portion of the chips that the company's Internet of Things Group sells, too.  

While it's not ideal that Intel can't meet all the demand it's seeing from its customers, the company appears to be trying to make the best of the situation it's faced with. 

Intel is trying to catch up in 2019

During the question-and-answer session on Intel's third-quarter earnings call, Swan outlined the plan to get supply and demand back into balance. 

He pointed to the fact that Intel has "put a lot of capital to work this year," referring to the company's freshly increased 2018 capital expenditure budget of $15.5 billion (up from $15 billion in July which was itself revised from $14 billion in January). He also explained that the company has "taken some of [its] 10 [nanometer] equipment and tools and began to blow that back to meet the increased demand for 14 [nanometer]."

"So, we're working extremely hard to get back on track in 2019," Swan said. 

When Intel reports its fourth-quarter results in January, it will likely issue financial guidance for the entirety of 2019. It will be interesting to hear when Intel expects to achieve supply-to-demand balance as well as how much additional demand the company expects to see in 2019. Swan did say that Intel is betting that 2019 will be another record year for the company. 

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