Can Intel Manufacture An Edge?

By Stephen D. Simpson, CFA | July 18, 2012 AAA

Companies have been lining up to tell investors how tough the PC market is these days, so there was a little bit of relief when Intel's (Nasdaq:INTC) second quarter numbers were basically on target. The issue for investors, though, is that near-term pressures in the PC market and a relatively unimpressive valuation could well weigh on shares even as the company has an improving long-term outlook.

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Q2 Solid in Many Respects
Intel's nearly 5% sequential revenue growth for the second quarter was a solid outcome in a tough market. PC revenue rose 4% sequentially despite 2% ASP erosion, while the data center business continues to grow nicely (up 14%) on the Romley ramp. Intel's software business also did alright (up almost 3%).

Gross margin was surprisingly strong, though down about a half-point from the first quarter. Margins got a boost from the sale of previously reserved inventory, though, so quality is an issue. Operating income fell 3% from last year and rose less than 1% from the first quarter as the company continues to put more resources into R&D.

SEE: Zooming In On Net Operating Income

Guidance Not Really a Surprise
With AMD's (NYSE:AMD) surprisingly large miss and lower guidance/outlooks from Acer, Asus and Seagate (Nasdaq:STX), it was no surprise to see Intel take its numbers down a bit. At this point it is worth wondering whether the big Microsoft (Nasdaq:MSFT) Windows refresh cycle is going to really help the PC supply chain this year. Clearly, initial expectations were much too optimistic.

Familiar Worries from the Bear Side
One of the more popular bear stories on Intel these days is that the company's gross margins have peaked. With a low-quality GM beat this quarter and inventory at a six-year high, I can understand those concerns to a point.

It's pretty clear, for instance, that Intel is not going to let AMD gain back much traction in PCs. What's more, while I accept management's explanation that inventory has been inflated by more expensive Ivy Bridge chips, the fact remains that a bigger-than-expected macro slowdown would turn that inventory into an albatross for margins.

SEE: A Look At Corporate Profit Margins

Will Fabs Drive Share?
With Atom, Intel is starting to make inroads into the smartphone and tablet markets. Although I question Intel's apparent preference to support Windows tablets instead of Android tablets, the company has seen some encouraging sign-ups in smartphones and tablets.

Processors based on ARM Holdings' (Nasdaq:ARMH) technology have clearly stolen the march on Intel in smartphones and tablets, and that's been known for quite some time now. What I find interesting is how that may change in the future. Witness Qualcomm's (Nasdaq:QCOM) challenges with Taiwan Semiconductor (NYSE:TSM) and maybe you can appreciate the virtues of controlling your own manufacturing.

Intel is not a perfect manufacturer, and the company has had its own challenges with generational migrations, but I do believe the company's manufacturing capabilities could give it an advantage in the next few years and allow it to bring advanced chips to market faster than its fabless competitors. Moreover, I think moves like its recent investment in ASML (Nasdaq:ASML) is a big step in that direction. Keep in mind, though, that Texas Instruments (Nasdaq:TXN) and Samsung have their own fab capabilities too, so Intel's advantage isn't absolute.

SEE: Competitive Advantage Counts

The Bottom Line
I believe Intel has the opportunity to leverage its fabs and manufacturing capabilities and attain a technology and time-to-market advantage on fabless ARM-based competitors. However, that's not going to happen tomorrow and Intel's stock has outperformed the semiconductor sector by a pretty substantial margin over the past year.

If Intel can grow its cash flow at a roughly 6% compound rate over the next decade (versus nearly 10% over the past decade), these shares look as though they should be worth something a little north of $30. That makes them a good hold in my book, but I'd need to see the price pull back another 10% or so before being a more enthusiastic buyer.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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