Intel Looks Marvelous

Before we jump into Intel's (Nasdaq: INTC) earnings, there's plenty of action for other Rule Maker companies this week. Coca-Cola (NYSE: KO) reported second quarter worldwide unit case volume growth of 7% -- ahead of last month's guidance of 5% to 6% -- on sales of $5.6 billion (check out the conference call).

Microsoft (Nasdaq: MSFT) reported flat fourth quarter sales of $5.8 billion, and net income of $2.4 billion -- including $1.1 billion in gains from investments. Without the additional gains, income would have fallen below last year's mark of $2.2 billion. Look for Rule Maker writer Zeke Ashton to take a closer look at Microsoft on Friday and Coke in a later report.

After the market closed last night, Intel released its second quarter earnings. Based upon what I learned listening to the conference call, both Intel and the Wise were pleased with the results, which were solid from a Rule Maker perspective as well. Fool writer Paul Larson covered the earnings this morning.

Intel Capital
One of the most controversial issues related to Intel's results is the significant contribution of Intel Capital to its bottom line. In the past, I've taken the view that there's no reason to worry too much about the level of its contribution to Intel's profits. These are strategic investments that allow Intel to enhance its ability to sell more products and compete in the marketplace. In that vein, the most significant contributor to the performance of Intel Capital this quarter was the sale of the vast majority of its shares of Micron Technologies (NYSE: MU). According to Intel's CFO, Andy Bryant, this stock was sold because it's no longer viewed as strategic.

While I can't say that a portfolio that holds 450 securities is Rule Makerish in any way, I can say I have some expectations that the companies we hold in our Maker portfolio will have lots of loose cash to invest -- and I want to see that they're benefiting from that cash. But, it's also clear that Intel can't be expected to generate $2.3 billion from such investments on a regular basis.

This is particularly true since the size of Intel's portfolio declined to $7.5 billion from $10.8 billion, which reflects the sale of assets as well as a decline in equity values. In addition, Intel reported that the unrealized gains in the portfolio declined by approximately $3.2 billion. So, including such amounts in operating results will lead to more erratic earnings performance than we expect from our investments. I'll discuss how I approached this issue in the discussion of Net Margin for the quarter.

I'll prepare an updated Rule Maker Ranker for Intel and post it on our Companies board after I get a chance to review the second quarter numbers for Advanced Micro Devices (NYSE: AMD), which will be released after the market closes tonight. However, based upon Intel's results, I'd be quite surprised if it didn't post another Top Tier score of 50 or more.

During the conference call, Intel expressed as much optimism about the current quarter and the quarter to come as I can ever recall. CFO Andy Bryant said Intel is "more confident going into the third quarter than it has been in a long time." In addition, based upon conversations with customers it's expected that the third quarter results will be linear (i.e., sales should be relatively smooth during the course of the quarter).

In addition, Paul Otellini, Executive Vice President and General Manager of Intel Architecture Group indicated that he was very pleased with the second quarter results. Demand was unseasonably strong throughout the quarter. Intel was able to take advantage of its continued conversion to 0.18-micron microprocessor production, which led to record shipments during the quarter. Over 50% of the CPUs shipped during the quarter were manufactured via 0.18-micron manufacturing technology. It is expected that this figure will exceed 90% by year's end.

Still not meeting demand
Intel still isn't able to meet demand. Unfortunately, Intel (and many other companies including some suppliers) failed to accurately forecast the explosive demand for product driven by the rapid adoption of the Internet and the build out of the infrastructure required for further Internet transaction growth.

While Intel is better able to meet demand now than it was during the first quarter, it has certainly not been able to increase its inventory levels as much as it would like. This applies in the case of its distributors, its inventory channel, and its warehouses. Intel has made significant investments in new facilities this year by purchasing a plant in Colorado Springs and starting the production of new fabrication plants in both New Mexico and Ireland. As these plants come on line and the conversion to 0.18-micron manufacturing technology continues to ramp up, it is expected that Intel will be able to meet demand.

Of course, the downside here is that Intel's failure to meet demand increases the opportunity for AMD to take business. This is something that could certainly cost Intel in the future. However, the fact that Intel is so much stronger than AMD financially, as well as the fact that its business is better diversified leads me to believe that Intel will continue to be the dominant company in this space for the foreseeable future.

In addition, during the conference call Intel expressed its belief that it continues to gain market share. AMD has been unable to make serious inroads in the commercial marketplace. AMD has been able to make inroads into the consumer market via arrangements like the one it has with Gateway (NYSE: GTW), but from what I've read there is still great resistance by major businesses to use PC's with AMD microprocessors.

Rule Maker criteria
Now let's take a look at Intel's Rule Maker numbers for the quarter. (Click here for the full list of Rule Maker criteria.)

Sales Growth of at least 10% -- Intel was able to grow its sales by an impressive 23% over the year-ago figure. There's no reason it won't meet our target in the future. The two key business segments for Intel continue to be microprocessors and flash memory chips (which primarily go into cell phones). Microprocessors for laptop PCs were up 40% year over year and continue to outpace desktop microprocessor growth.

Flash memory sales during the quarter set a new record in terms of units, average selling prices, and revenues. Intel's network communications group also continues to perform quite well, as revenues grew by 50% over the year-ago result. Average selling prices were about even for the quarter and there was relatively little change in overall market distribution of its products.

Intel did announce that the target date for when it will start recognizing revenue from its 64-bit Itanium processor has slipped to the fourth quarter. Those revenues will only be from computers using the chip in "pilot systems." The delay is primarily related to the company's desire to have the chip as bulletproof as possible when it's released.

On a geographic basis, demand in the Americas, Asia Pacific and Japan were all up sequentially while Europe had its normal seasonal downturn. Japan and Asia Pacific demand has been particularly strong, as the region has emerged from its recent recession. Internet adoption in those countries is now mirroring that of the U.S. (though on a lagging basis).

Gross Margin of at least 50% -- Despite the fact that Intel took a $200 million charge related to its MTH motherboard replacement program during the quarter, it was still able to record gross margin for the quarter of 60.4%, an improvement over the year ago figure of 59.4%. Without the charge (which was appropriately included in operating results), Intel's gross margin would have been 62.9%, which is a slight increase over the 62.6% reported last quarter. Guidance for the year is now that gross margin will be 63% plus or minus a couple of points, which is an increase over the 61% guidance given last quarter.

Net margins of at least 7% -- This is one that I'm sure can be interpreted differently by each investor. I decided to ignore the interest and other income amounts. For my calculation, I used pro forma operating earnings as provided in the press release of 2,823 and applied the 31.8% tax rate listed in the press release to this income. This resulted in net income of $1,925 million and net margin of 23.2%. I performed a similar calculation for last year using the slightly higher tax rate of 32.8% that applied to last year's earnings. This resulted in net income of $1,559 million and net margin of 23.1%.

Cash-to-Debt ratio of at least 1.5 -- Intel now has a cash hoard of $13.6 billion, and it has $385 million of short-term debt and $870 of long-term debt. That gives it a ratio of 10.9. This is a strong result though it is down from the year ago figure of 13.2. Intel's business continues to throw off significant cash. Unfortunately, we can't check the Foolish Cash-King margin until its 10Q is released next month.

Foolish Flow Ratio of no more than 1.25 -- Intel's flow ratio fell to an impressive 0.87, a sharp decrease from the year ago figure of 1.18. There is a possibility that this number could increase a bit later in the future, as Intel would ultimately like to replenish its inventory levels a bit. One point of concern here is that accounts receivable growth during the quarter was greater than sales growth. During the call, Andy Bryant indicated that there were an unusually large amount of sales ($655 million) at the end of the quarter that impacted this result. This also led to an increase in Intel's Days Sales Outstanding (Accounts Receivable / (Sales/90)) of three days. I'm willing to accept Intel's explanation for this item, but it is something that I'll check back in on next quarter.

All in all, if you're an investor with a focus on the long-term, while there are a couple of things to keep a watchful eye on, this was yet another solid quarter for Intel. The company continues to look good when run though our investment criteria.

Phil Weiss (TMFGrape on the boards)

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