Intel (NASDAQ:INTC) closed out fiscal 2006 facing significant challenges to multiple levels of its operating performance. In its fourth-quarter figures, you'll find a 5% drop in net revenues, while operating margins sank by 17 percentage points.
Recent news from the chip giant isn't all negative, however. My Foolish colleague Anders Bylund points out that the company has regained the performance edge against AMD (NYSE:AMD) with its new processing technology.
To help us obtain a clearer understanding of how things will shape up for Intel over the near term, this edition of Fool on Call will dive into the company's latest quarterly earnings conference call, and particularly its examination of gross margins.
Margin improvement? Not just yet
Intel's leadership made some prepared remarks during the call, but I found that the best bits of information were revealed during the question-and-answer session. There, the conversation quickly turned to profit margins for 2007.
In the fourth quarter, softening sales and other factors drove gross margins down to roughly 50%, a significant drop from year-ago levels of nearly 62%. No wonder analysts spent the bulk of the call trying to get more clarity on Intel's margin situation.
In its 2007 guidance, management estimated that gross margins will remain in the 50% range. When asked to comment further on the lack of projected improvement, CFO Andy Bryant offered several explanations.
On average, he said, Intel experiences about a 2% hit to margins as result of start-up costs, which can range from implementing a new process to opening a new factory. In 2007, however, start-up costs will result in "approximately four points of margin deterioration," primarily because of the company's shift from older 90-nanometer manufacturing processes to more efficient 45-nm technology.
Investors should also note that approximately 70% of these costs will occur primarily in the first half of 2007. Management estimates that first-quarter gross margins will be squeezed even further, down to around 49% -- perhaps even a point or two more. In the second half of the year, we should see gross margins back around the lower 50s, and possibly even higher.
Intel is expected to offset higher start-up costs through various cost-cutting initiatives, including trimming 10,500 employees -- a 10% reduction in its labor force compared to 2006 levels. When later asked by an analyst why the large reduction in labor won't have a more positive influence on margins, Bryant responded, "We do believe it's still going to be [a] competitive business environment, and we're going to have to have to fight to win orders." An analyst pressed Bryant to speak further on the competitive environment. However, he declined to comment on projected price declines.
Investors may be concerned with Intel's plans to cut research and development costs by $500 million in 2007. Obviously, R&D is critically important to this industry, so one would hope that that the lower figure is less a reflection of future poorer performance in this area than the result of cost savings from outsourcing initiatives.
It looks like shareholders will have to get comfortable with 50% gross margins, at least over the short term. One analyst did ask whether gross margins can ever get back into the 60% range, but management refused to offer a long-term forecast. Based on information revealed in the call, however, I think there are several reasons to believe that Intel can get back up to the 60% level, perhaps as early as 2008.
First, start-up costs are expected to normalize in the back half of 2007 and into 2008. Second, a 10% reduction in the workforce is no drop in the bucket, and I anticipate seeing significant cost savings here. And finally, while competitive pressures will remain significant, there's good reason to believe the pricing environment will be slightly improved in 2008.
My basis for this last point comes from remarks made by CEO Paul Otellini during the Q&A portion of the call. He indicated that in 2006 Intel experienced the "biggest single series of price moves" in its history. This was a result of bringing on new products in all three of its major categories -- servers, desktops, and notebooks. With the introduction of 40 new products, prices on the old products had to be cut. These drops were one reason for margins' tumble to the 50% level.
So while the competitive environment will remain the same, it's unlikely that we'll see Intel get similarly bonked on the head with a triple whammy of price hits in 2008. A slightly improved pricing environment, accompanied by cost savings initiatives, should lead to significant improvements to profitability, particularly if there is some solid revenue growth in 2008.
The worst may be over
My colleague Anders Bylund indicated that AMD and its process partner IBM (NYSE:IBM) will be scrapping and clawing to catch back up with Intel and its 45-nm production lines, but that it won't happen overnight. In fact, he argues that AMD is roughly about a year behind Intel on this front.
Intel's advantage over AMD won't come without costs, as we've already noted. But shareholders should see improvements in profitability in the back half of the year, and I think there's evidence to suggest that profits will continue to improve into 2008. With Microsoft's (NASDAQ:MSFT) Vista creating a favorable consumer environment, and with Intel's newly regained technological superiority, there's reason for optimism as the company moves into the back half of 2007 and into 2008.
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Fool contributor Jeremy MacNealy has no financial interest in any company mentioned. The Motley Fool has a disclosure policy.
