The Barron's article:
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Zero Hour
Even as Intel's prospects start to look cloudy, investors refuse to see anything but blue skies
By Jay Palmer
Few companies dominate their industries the way Intel
dominates the $25 billion microprocessor industry.
Relying on a combination of design excellence and
unparalleled manufacturing efficiency, the Santa
Clara-based colossus has captured an almost obscene 80%
share of the market for personal computer chips. That,
coupled with the inexorable rise in PC sales, has helped
Intel post average annual earnings growth of nearly 30%
for more than two decades.
Wall Street analysts look for the stock to continue shooting higher, rising from a recent price of 75 a share tomore than 100 in the not too distant future. Among big-time technology money managers, Intel remains an almost universally popular core holding. The company is expected to earn about $8 billion this year, or $2.30 a share, on revenues approaching $30 billion.
Intel has been a prime engine
behind the computer revolution
that's swept America in the past
two decades. And investors who
have recognized that have
profited mightily. Since 1985,
Intel's share price has risen
6,300%, versus an 800% gain
for the Standard & Poor's 500
Index.
But what many investors may not
understand is that Intel's
business is changing dramatically. The company stands at
what co-founder and former chief executive Andrew Grove
calls an "inflection point," a critical moment of change that must be identified and managed if a company is to continue to be successful.
For Intel, which has historically garnered an estimated
80% of its sales and 100% of profits from high-powered
chips for personal computers, the moment of inflection
came last year when the sudden popularity of PCs selling
for less than $1,000 began to cannibalize the longstanding sales growth of high-end PCs. From less than 30% in 1997, sub-$1,000 PCs have swelled to the point where they now account for more than 60% of units sold. Such a tectonic shift has altered the landscape of Intel's business in a way that, quite simply, threatens the company's ability to maintain its historic rate of profit growth. Next year, for example, Intel's earnings are expected to rise by less than 20%. Yet Intel's stock price reflects none of this risk. The shares
currently trade at 33 times consensus estimates for 1999
and 28 times estimates for 2000. That's nearly twice the
company's expected growth rate in 2000. If Intel's multiple were to drop to, say, 1.5 times growth, its shares would trade at around 59. And if they were to trade at one times growth, the shares would fetch just 39. Once investors wake up to the fact that Intel's glory days are over, that could easily happen.
That said, Intel is deservedly rated one of America's
best-managed companies. And though it may have been
slow to wake up to the threat to its core business, it has not been totally asleep at the switch. Over the past 18 months, Chief Executive Craig Barrett has taken steps to make the best of a bad situation. Recognizing that the PC chip
business may never be the engine of growth it once was,
Barrett is redirecting Intel into a new market, the Internet.
In essence, Intel wants to move up the food chain and
become a supplier of chips to servers and networking
devices, the high-end computers that power the Internet.
And given the sheer potential of the 'Net, combined with
Intel's track record, Barrett's strategy looks smart. The
server market alone is growing at around 35% a year,
compared to just 15% growth for PCs. Yet this new
strategy by definition remains untried. Powerhouses in the
server business, like IBM and Sun Microsystems, are not
likely to willingly cede market share to Intel. And
heavyweight networking chipmakers like Motorola and
Texas Instruments aren't likely to roll over and play dead,
either.
Nor is it assured that the growth of the Internet will
continue in hyperdrive. If the rollout of broadband access
to the American home comes slower than expected,
demand for Intel-powered servers and networking devices
may not prove strong enough to make up for the slowdown
in the company's revenue growth from the PC market.
"The simple fact is that while it may be dangerous to bet on
Intel failing, its new ventures are anything but guaranteed,"
says Howard Anderson, president of the Yankee Group.
"Investors think Intel is bulletproof, but it isn't."
In a very real sense, Intel has prospered over the last
30-odd years by following one basic tenet, Moore's Law. It
was back in 1965 that young Gordon Moore, then an
engineer at Fairchild Semiconductor and later Intel's chief
executive, first postulated that technological advances
would allow the number of transistors on a chip to double
every 18-24 months, thus doubling potential computing
power. Much as E=MC2 opened the door for nuclear
power and the atomic bomb, Moore's Law provided a
roadmap to success, and Intel executives took it straight to
the bank. Beginning with the 8088 chip in 1981, Intel has
churned out a steady stream of everfaster microprocessors
-- 8086, 286, 386, 486 and the Pentiums I, II and III-each
setting the standard for performance and each consequently
selling at a premium price.
A basic pillar of this strategy, of course, was that PC
makers, not to mention PC buyers, saw the faster chips as a
"must-have" product. For throughout all the early PC years,
there was hardly a time when software wasn't running
ahead of hardware or when PC owners didn't find that the
machine acquired just 12 or 18 months earlier could no
longer run the latest versions of many popular programs. It
was part of Intel's credo that everyone always wanted the
newest and best chip. That is, until last year.
Exactly what happened in 1998 is something sociologists
and economists will be writing about for years to come.
Some say it had to do with the economic laws of
diminishing returns and the near-saturation of the U.S. PC
marketover 70% of homes with kids now have a machine.
Others, like Intel's Barrett, cite the Asian economic crisis,
which forced memory-chip and disc-drive makers to sell
their products below cost just to keep their factories
operating. Still others insist it all had to do with software,
especially the fact that these "good enough" PCs happily
run just about 99% of all the software on the market,
including the browsers and graphics programs needed to
access the Internet.
Whatever the case, cheap PCs became the standard
overnight. Companies like Compaq and Gateway and
scores of no-name brands began pumping out sub$1,000
PCs at a ferocious clip. And most were powered with
cheaper non-Intel chips. As if that weren't bad enough, it
soon became apparent that the cheaper machines were not
so much attracting a new breed of skinflint customers -- as
some in the business had hoped -- as cannibalizing the
existing market for mid-priced higher-powered PCs. As a
result, over the first half of 1998, demand for Intel's
top-of-the-line Pentium chips faded faster than underwear
at an orgy, knocking sales lower and cutting earnings by
36% in the first quarter and 28% in the second.
With its stock in a dive-Intel's shares fell to as low as 35 in
mid-1998-the company's first reaction was to slash the
prices of its older, low-end Pentium chips almost in half to
make them competitive with chips from Advanced Micro
Devices and Cyrix, which were being used to power these
new cheap PCs. Intel's response was to rush to market with
its new, relatively low-performance and relatively
inexpensive Celeron chip. Though there were a few
glitches along the way, that move, combined with further
price cuts this year, subsequently won back much of the
market share lost in those initial months. Certainly, from
Intel's perspective, it would have been dangerous to
surrender the low end of the market on a permanent basis,
since that would have left AMD and others with a base
from which to expand up into Intel's main market.
Intel maintains that the margins on its low-end Celeron
chip are not that different from those of its high-end chips.
Perhaps so, but that still means that the company has to sell
five $100 Celeron chips it makes to one Pentium III. And
with sub-$1,000 PCs here to stay and the market growing
overall at just 15% a year, that limits the long-term
potential.
Barrett, a 25-year Intel veteran who was named CEO in
May 1998, first made his mark at the company in the late
1980s, when U.S. chipmakers were under attack from their
Japanese competitors. At the time, Intel was so battered
that it was forced to lay off 20% of its work force and shut
down its memory-chip operations just to survive. Rather
than focus on what rivals like Hitachi, NEC and Toshiba
were doing wrong-many in the industry accused them of
dumping products below cost-Barrett, a soft-spoken former
Stanford professor, took a close look at what they were
doing right. Dumping or no, he recognized that his Asian
competitors were turning out silicon cheaper, faster and
better than anyone else.
His response was to go on a whirlwind tour, visiting U.S.
chipmaking equipment companies to get detailed
descriptions of just how Japanese chip plants used their
machines, touring plants owned by Intel's Japanese allies,
and even going out of his way to get reports from chip
customers of what they had seen while visiting Japanese
facilities. His conclusion was that while Intel still excelled
at chip design, its manufacturing process was downright
inefficient. It was Barrett who led the effort to overhaul
manufacturing from the bottom up, setting the stage for the
company to become widely recognized as the single most
efficient chip maker of the 'Nineties.
"For the previous 15 years or so, no one had really paid
attention to the idea that we needed to be efficient," says
Barrett. "It was enough to be a technology-creation
machine."
The challege Barrett faces today is less specific than the
one he faced a decade ago, but it is no less urgent. "If life
at Intel was based on just the sub-$1,000 PC market, it
would be painful," he concedes with a grin. He adds,
however, that there are new software applications out there
on the consumer horizon, like speech recognition, digital
imaging and video conferencing, that will require high
powered PCs. And as they take hold, he says, PC buyers
may once again start moving up to higher-priced models.
That said, he's not waiting around for the high-end PC
business to come screaming back. Intel's next growth
engine, he says, will be the Internet. "From our
perspective, the continuing boom in Internet traffic will
create an immense market for an infrastructure of
workstations, servers and networking devices. Job 1 at
Intel is to be the building-block supplier of the Internet
economy."
Consider the server market. These high-end computers
form the backbone of the World Wide Web, not only
storing and transmitting the data, but also controlling,
policing and supervising the flow of information-plus
operating millions of Web pages. Barrett, who can be
excused for holding an optimistic view of the market
potential, figures that the number of servers needed to
manage the 'Net could grow exponentially over the next
five years.
"Just take the rule of thumb that for every 10 PCs on the
Internet you need one server," says Barrett. "I'm looking
out and I see a billion Internet users. On that basis I'll need
100 million servers, roughly 20 times the number that exist
today. It's a huge potential market." Industry analysts differ
in their projections, but most agree that we are looking at a
total chip server market which could quickly eclipse PCs
in importance and size.
Barrett maintains that selling server chips is not that
different from selling PC chips for PCs. While they are
manufactured by a variety of firms, including IBM,
Hewlett-Packard and Dell Computer, the key element is
the processor, a business Intel knows well. To win
business from established server chip makers, Intel will be
peddling a range of offerings starting with its Pentium III
processors and the blazingly fast Pentium Xeon processor
that was rolled out in June '98. Next year, Intel plans to
launch its 64-bit Intel chip, code-named Merced. And to
further kick-start its way into the Internet business, Intel
quadrupled its research and development spending to an
astonishing $8 billion last year.
A second and no less important leg of Intel's Internet
strategy is designing and manufacturing chips for
networking devices, the powerful computers that control
traffic over the Web. Much like a traffic cop, networking
computers analyze the differences between voice and data,
determine whether data are coming or going, assign
importance and priorities to traffic and control just what
data get sent when and to whom.
Intel chips are already being bought by the likes of Cisco
Systems, Lucent and Nortel, the major communications
vendors, but the Santa Clara company wants a bigger slice
of the pie. Toward that end, over the past two years, Intel
has spent roughly $8 billion to invest in or buy outright
eight different companies, many in some way key to the
networking push. Especially important was the acquisition
of StrongARM, a novel chip design that can be used in
high-end switchers and routers from Digital Equipment
and the $2.7 billion purchase just this year of Level One, a
maker of chips that combine analog and digital
technologies in local and wide-area networks. A key
element of Intel's new strategy is not just to sell the chips
into this expanding market but also to try to lay down some
basic guidelines on how network chips interact with one
another. Last month, Intel unveiled its new Internet
Exchange Architecture (or IEA), in effect a blueprint for
networking based on a new Intel family of products.
What Intel is in effect attempting to do is replay the PC
model in networking. Just as there were many different
standards for PCs in the early 1980s, not all of which were
compatible with one another, there are many standards for
networking today, and few are compatible with each other.
If Intel has its way, the standards would merge, and Intel
would be the biggest beneficiary.
"If you step back and look at the big picture, you find that
nature rather abhors narrow vertical solutions to anything,"
says Barrett. "Nature likes horizontal solutions with
standard building blocks and open interfaces. Being a
success in this market is not dissimilar to being a success
in the PC market. You don't just create one device. You
create an architecture, a processor plus a way of doing
things. You're throwing out a complete solution. That's the
strength of our push."
Intel's most exciting offer ing in this market so far is the
IXP1200 network processor, one of a new breed of
interchangeable programmable chips from In tel that will
allow network system designers to add functions to chips
even after they are installed with software. Competitive
chips from the likes of Motorola, AMD and Texas
Instruments are pre-programmed for their particular
function and not changeable once installed.
However, the Intel Inside concept may not give the
company the same kick in this market that it gets from PCs.
Says Yankee Group's Howard Anderson, "If you knew that
Domino Sugar was in Coke, would that make you buy it
instead of Pepsi?" In other words, explains Anderson, the
guts of the machine are less important to customers than
what they actually do. What's more, he says, "The industry
is deadly afraid of letting Intel be the power in networking
that they are in PCs."
Intel is also keeping a close eye on the interactive
market-everything from Palm Pilots and TV-set Internet
access boxes. In one sense, this growing market represents
a threat to Intel's core PC business. After all, if people
migrate toward special-purpose PCs, and away from
Intel-based PCs, Intel's PC processor business could be
even further eroded. Barrett, however, chooses to see it as
an opportunity for Intel's lowestend processors, including
a variant of its StrongARM chip designed to run in
low-powered units on AA batteries. "When I read stories
about how Intel has missed out on the appliance wave," he
says, "I wonder if those people ever took high school
math. Sure, the chip we make for such a device may sell
for only $20. But if you are talking about a market for 100
million such devices, that's still 100 million times $20, or
$2 billion. It may not be huge, but that's still between 5%
and 10% of our current microprocessor business."
A growing awareness of these heady prospects helps
explain just why Intel stock has raced ahead to the present
76 from a low of about 50 in May, outstripping both the
S&P 500 and the benchmark semiconductor index by a
wide margin. Yet there is a very real danger that, in its
enthusiasm, the market has gone too far, too fast.
Let us look first at the numbers. This year, with six months
in the bag and third-quarter numbers, due out within
weeks, set to be upbeat, Street analysts are shooting for
earnings as high as $2.40 a share, with a consensus
somewhere around $2.30 -- an advance of 29% over the
very depressed 1998 return. In 2000, at least one bull
figures Intel could earn $2.90 a share, but most are a lot
closer to $2.70, up just 17% over 1999. On the basis of
those consensus numbers, the stock is trading at multiples
of 33 for 1999 and 28 for 2000, roughly twice the
underlying rate of growth in earnings.
By comparison, the S&P 500 index trades at roughly 1.5
times 1999 growth estimates. This is significant, because
Intel has long tracked the S&P pretty closely on this
measure. But now, just as the company faces the challenge
of remaking itself with all the attendant risks that this
entails, its shares have raced ahead to the point that they
trade at a substantial premium.
And while Intel seems to have a clear strategy going
forward, there is much that could go wrong. What if, for
example, the competition for server chips from the likes of
Sun, HewlettPackard and IBM proves fiercer than
expected? And what if Intel has a tough time trying to
dictate networking standards and that new Internet
architecture fails to catch on as quickly as hoped? And
what if Intel's new Merced chip, already delayed for a
year, faces even further delays next year? And what if the
rollout of broadband Internet services to American homes
takes longer to accomplish than the phone companies and
cable companies, which are racing to get there first,
anticipate?
None of these factors are under Intel's control any more
than the cannibalizing of the PC market by sub-$1,000 PCs
was. Says Greg Blatnik, vice president at Zona Research:
"Intel is performing a delicate balancing act in these new
markets. In the past it had the advantage of owning the
market, of being a benevolent dictator. But that's changed.
They now face new competition and the difficulties of
establishing new relationships with customers. I think
they'll succeed but there is certainly a risk that things will
not work out as planned."
Factoring in the current risk, the company's shares should
probably trade at a P/E equal to 1.5 times the company's
17% pace of earnings growth. As noted earlier, that's
somewhere south of 60. No matter how good Intel
management and how bullish the prospects, anything above
that is all fluff.
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What is the big deal?
John
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