Investors following chip giant Intel (NASDAQ:INTC) are likely aware the company has been losing billions per year for several years now in a bid to become relevant in the market for smartphone/tablet processors.
These losses peaked at a hair over $4.2 billion in 2014 thanks to a combination of high operating expenses coupled with substantial contra-revenue payments to customers to offset platform-level cost deficiencies associated with its tablet processors.
As I wrote in an earlier column, Intel expects this loss will be reduced by more than $800 million this year (company CFO Stacy Smith says it will be "closer to $1 billion") and by another $800 million next year.
Roughly two-thirds of the loss reduction in 2015 is expected to be due to "lowered investments" (i.e., spending cuts) while a third is expected to be due to improvements in product margins (the abatement of those contra-revenue payments likely helped).
In 2016, the reduction is expected to come mostly from product margin improvements, though a third of it is still expected to come from "lowered investments."
Interestingly, management reiterated its view that it expects this business can eventually be profitable. I don't believe the company will be able to really cut spending much (if at all) post-2016, which suggests the company will need to grow revenues fairly substantially in order to hit profitability.
In this column, I'd like to explore just what it would take for Intel to actually reach profitability in this segment and whether it can be done within a reasonable timeframe.
Beyond 2016, it'll have to be about shipping products at reasonable margins
Intel lost $4.2 billion in 2014, so if we assume a reduction in this loss of $1 billion in 2015 and then another $800 million reduction in 2016, the losses should come in at around $2.4 billion in 2016. Although the losses should improve significantly, they're still substantial.
I do not believe beyond 2016 that Intel will be able to realize significant operating expense reductions. Indeed, the operating expense cut portion of the loss reduction in 2016 is much smaller than it was in 2015, which suggests such cuts should be largely done with as 2017 rolls around.
This means in order for Intel to achieve profitability it will need to do two things:
- Improve mobile product margins
- Grow mobile revenues
Sadly, Intel didn't offer a whole lot of insight into what the current revenue/gross profit margin/operating expense profile of the company's mobile business looks like, which makes it hard to try to model it out. However, during Intel's 2014 investor meeting, Smith indicated the business would reach "gross margin breakeven" at some point in the first half of 2016.
Gross profit margins tend to be an indicator of the competitiveness of a company's product portfolio. The fact it will be an achievement to hit "gross margin breakeven" (i.e., gross profit margins of 0%) at some point in the first half of 2016 is as good an indication as any that the company's current mobile product portfolio is really not good.
That's the bad news. The good news is that if, by 2017, Intel can roll out a fairly competitive set of products (low-end/mid-range integrated applications processor and modem products, as well as discrete modem products), the company should be able to command average gross profit margins in the neighborhood of 35%.
Additionally, if the company's products are competitive, not only will Intel be able to sell them for a reasonable gross profit margin, but they'll be able to sell them, period. The combination of what might be significant gross profit margin expansion on a per-unit basis, coupled with increased demand for its products (and thus revenue growth), could be enough to bring this business to around breakeven by 2019.
Indeed, if Intel is able to realize a roughly ~$540 million improvement in product margins in 2016 (during which its product portfolio will still be quite poor), then I could see product margin improvements accelerating in 2017. If Intel can realize $800 million worth of product margin improvements in each of 2017, 2018, and 2019, then the business should hit breakeven.
Of course, this all depends on Intel making dramatic improvements in the competitiveness of its mobile products. Should it fail to do so, then break-even for this business -- should Intel choose to stay in it -- may not be achieved until much further out in time.