As an Intel (INTC +1.05%) investor, I have not been shy about both highlighting the company's strengths as well as really drilling into where the company has really failed to execute. That said, there seems to be a real misunderstanding among investors as well as the tech press alike that has served to put some investors on edge. The purpose of this article is to better explain this "contra-revenue" program and to help understand why it is actually a smart business move.
The bill-of-materials issue
At Intel's 2013 Investor Meeting, management admitted that the Bay Trail-T platform that it had developed specifically for tablets did not carry with it a competitive bill of materials. Now, you may be thinking that Bay Trail-T is just a single chip so this "bill of materials" is a cop-out, but that's far from the reality of the situation. A system-on-chip for tablets/phones or even PC chips requires an entire board full of components.
To put it in perspective, the original Bay Trail-T platform launched in September 2013 required no less than 700 components in order to support a full system design. For a $499 iPad Air-class product, this isn't a problem, but when you're trying to build a tablet that needs to be sold with positive gross margin for $129 or even $99, bringing these costs down is critical. MediaTek and Qualcomm (QCOM +0.24%) -- two of the leading system-on-chip vendors in tablets -- have this down pat.
Enter contra-revenue
So, say you're Intel and you've just developed this Bay Trail-T platform targeted at iPad-class products that typically sell for $300-$500, and all of a sudden the market around you has shifted toward $125-$250 devices. Further, suppose that your competitors have managed to beat your high end chip in critical dimensions of performance (Bay Trail-T's Achilles' heel – and Qualcomm's strength – is graphics).
Further, you're new to this market and you need to gain a pretty substantial footprint in the tablet market before it's too late. OEMs don't want your chip, as beastly as it would perform in low-end to mid-range tablets, because they can pay other chip vendors the same amount of money but it would cost them about $20 less per unit simply because the other companies have optimized the bill of materials for their platform better. What do you do? Contra-revenue.
The contra-revenue is an equalizer, not a "bribe"
Let's do some math. Assume that Intel and Qualcomm are both selling chips for $15. Intel's manufacturing lead allows it to pack more in there and get more performance from the transistors, so Intel's $15 chip performs better than the competitor's $15 chip (for the sake of argument). However, Intel's entire platform is $20 more expensive than the Qualcomm chip to implement and we're talking about a tablet that will sell for $199.
The OEM will go with the Qualcomm chip. Even if the Intel chip offers more performance, the chips offer mostly comparable performance as far as the end user is concerned, but the OEM could either pocket that $20 difference as margin or use that $20 to improve something more visible like including a bigger battery, higher resolution screen, or a more premium chassis. In this scenario, Intel has no chance.
But let's say you're Intel and you've got your team frantically working to make sure future platforms don't suffer this same bill-of-materials deficiency. You could either wait until next year to try to win designs with the right products or you could try to gain a footprint today by simply offering the platform bill-of-materials difference as part of any potential purchase deal to make it a non-issue for the OEM. Intel chose to gain the footprint today so that when it has the right product next year, it has proven itself to customers who will then presumably buy the new, improved, and profitable-for-Intel products.
Foolish bottom line
This is something where Intel was at a disadvantage relative to Qualcomm. Qualcomm hails from the world of smartphones, so optimizing the platform for cost effectiveness is in the company's DNA. But Intel has come from the notebook/desktop PC world, where component flexibility has typically been more important than platform cost as we are typically talking about systems ranging from $399 to $999 with very little margin for the device vendor.
Intel will get to that bill-of-materials parity next year with new products and its parts will be able to compete on their own merits while being profitable on a gross-margin dollar basis. This means a financial hit in 2014, but by 2015 the "contra-revenue" will be all but gone, allowing Intel to profitably attack the entire range of the tablet market. It all comes down to having products that compete well on performance and power.
