I've had my eye on Intel (NASDAQ:INTC) shares ever since they dropped below $20 a share in early March. I think the company's valuation is attractive, and based on my research, it should be in a much better competitive position with Advanced Micro Devices (NYSE:AMD) by the end of the year. However, one nagging problem about Intel has kept me from buying: the company's $3.1 billion worth of inventory at the end of its fiscal year in December. I've been waiting for more clarity on the company's inventory situation before taking action, but it looks like there's no light at the end of that tunnel yet.

As we mentioned yesterday, Intel's sales and margins were down. But we didn't note that inventories climbed to $3.6 billion. In the grand scheme of things, that's about the worst trend any company can have. Here's how Intel's inventory, margin, and sales growth stack up:

Year-over-Year Growth

Inventory 26.5%

Gross Margin

-4.2 percentage points

Sales

-5.2%


The news gets worse. On its conference call, Intel disclosed that there has also been an inventory buildup in its sales channels, estimated at one to two weeks' worth of inventory. Coupled with the company's own large stash of goods, this backlog prompted the company to reduce sales and margin expectations for its second quarter. I think Intel may not get its inventory cleaned up until year's end; it has several product launches due in the third and fourth quarters, and it'll need to build up inventory to support them.

Here's the better news: Going into the earnings report, Intel's shares were already fairly cheap. The company has an improved product lineup on the way, and its expanding relationship with Apple Computer (NASDAQ:AAPL) should also help in the long term. My best guess is that Intel should begin to improve in the fourth quarter, when its new products are hitting the shelves and Microsoft (NASDAQ:MSFT) has begun its launch of Vista.

In the end, Intel has enough balance sheet strength to survive, and it trades at a reasonable valuation. But I'm still concerned things could get worse before they get better, and that "better" won't work out as well as I've hoped. Before I put any money on the line, I'm going to monitor the inventory situation, and revisit some of my assumptions about the potential performance of Intel's new products.

Further Foolishness inside:

Intel and Microsoft are both Motley Fool Inside Value selections. To find more of the market's best bargains, try a free 30-day guest pass.

Nathan Parmelee owns shares in Microsoft, but has no financial interest in any of the other companies mentioned. The Fool has an ironclad disclosure policy.