Intel Again
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Bull Argument
By Brian Lund (TMF Tardior)
Intel (Nasdaq: INTC) has been one of the most innovative and profitable companies in the 20th century. Its management, sales, and marketing teams -- not to mention its research and development -- have made it the King of Microprocessors ever since Intel invented the darn thing in 1971. It has so dominated the industry that it is able to maintain profit margins in excess of 25%, despite operating in a commodity industry. Intel is becoming more than just the Processor Potentate, however. As it expands into network and wireless communication equipment, it positions itself to profit in higher-growth industries.
The power of the Intel processor
Intel bears dwell on the fact that Intel has lost the high-end processor lead to Advanced Micro Devices (NYSE: AMD), whose Athlon has bested the Pentium III. Citing the delays in its next-generation 820 chipset a year ago and its subsequent recall, bears say that Intel hasn't displayed processor innovation for some time. These things are true. Intel has trailed AMD in innovation over the last year.
But, has it really hurt Intel? Here's an article discussing AMD's Athlon chip at its release, and the implications for Intel. Notice the date on the article -- August 12, 1999, more than one year ago. So, Intel has lost market share, right? Er, no. One year ago, Intel had more than 80% of the microprocessor market. Today it has -- drum roll please -- more than 80%. AMD has apparently taken market share from Cyrix and IDT, but not Intel. After 20 years of competing with AMD, despite fears and changes in technology, Intel still dominates the microprocessor market.
Surely the Athlon and its accompanying price pressures have been disastrous for Intel's margins, right? Again, no. In the third quarter of 1999, its gross margins were 58.7% and after-tax operating margins were 21.1%. In Q3 of 2000, they were 63.9% and 24.7%, respectively. Those are Intel's highest gross margins in years, despite trailing AMD in the high-end processor race.
AMD may be coming on strong -- and more power to it -- but it hasn't hurt Intel yet. Gross margins will decrease slightly in the near future because of the costs associated with the 1.4 GHz Pentium IV production ramp-up, but that product will also keep Intel on top.
Processor sales still growing
Your Intel bear may also say that the processor business is passé, that it can't muster the kind of growth rate that the market has priced into Intel. He may also suggest that the recent enormous increase in chip production capacity at Intel and AMD will cause a supply glut. I don't agree with either of those claims.
As Business Week reports, "More than 350 million computers were sold last year, and that number should increase at least 20% in 2000, according to projections from technology consulting outfit Gartner Group. If that growth holds up, it will soak up the excess production coming from both chipmakers' new plants." Then there's the high-growth server market, where Intel has grabbed significant market share with the Xeon chipset, a high-margin product.
The notion of "dumbing down" the PC has been way overdone, too. I can't imagine that networking will allow us all to have basic, "dumb terminals" at our desks. One of the happiest days in my life was the day that the Fool replaced the Pentium II 266 MHz I used to work on with my current Pentium III 600 MHz. Even on a network, the power of the end computer will always be essential to maximize performance.
Expanding into new businesses
Even in the eventuality of zero growth in the processor market, however, Intel can do just fine. It has begun to diversify its revenue stream into networking and communications products -- and it has often become the leader in its area. Through the acquisition of Level One Communications in 1999, Intel increased its market share in the Local Area Network Application-Specific Standard Product segment from 21.8% in 1998 to 34.5% in 1999. Number-two vendor Lucent Technologies (NYSE: LU), meanwhile, dropped from 20.5% to 18.9%.
Intel has also made huge strides in wireless communication. It is the world's largest manufacturer of flash memory, which is essentially the random access memory (RAM) in digital cellular phones, digital cameras, LAN switches, PC cards for notebook computers, and other devices. Through its 1999 acquisition of DSP Communications, Intel is seeking to enter the logic or chipset side -- the processor -- of mobile devices.
In this area, Intel recently introduced its new XScale architecture. The beauty of XScale is that its power can be adjusted, running from 200 MHz on 1/20 of a watt, to 800 MHZ on just under a watt, according to the desired power capability, so that battery life can be preserved. Immediately after the XScale was unveiled at the Intel Developer Forum in August, rumor spread that Palm (Nasdaq: PALM) would use XScale in future generations of its PalmPilot.
Revenue growth and diversification
The long and short of it is that Intel has an unbelievably strong core business in microprocessors, where it dominates its industry as much as one company legally can. Intel is not resting on that business, however. The revenue mix is shifting rapidly from all-architecture (processors and motherboards) to other products. Take a look at this table of Intel's revenue:
Q3-00 Q2-00 Q1-00 Q4-99 Q3-99
Arch.($mil) 7038 6759 6609 6955 6268
Other ($mil) 1693 1541 1412 1257 1060
Total Rev Growth 19% 23% 13% 8% 9%
Arch Growth 12% 22% 3% 0% 1%
Other Growth 60% 30% 109% 94% 113%
Arch % of Rev 81% 81% 82% 85% 86%
While growth in the architecture segment has slowed, the "other" category, which is mostly revenue from network and communication groups, has grown significantly. The revenue mix has shifted from 86% architecture a year ago to 81% in the latest quarter.
Future growth
Intel expects the architecture segment to grow about 10% annually over the next five years, while "other" growth should approach 50%. Let's extrapolate trailing-12-month revenue (as of Q3) at those rates:
2001 2002 2003 2004 2005
Arch ($mil) 30097 31602 33182 34841 36583
Other ($mil) 8855 13282 19922 29884 44826
Total ($mil) 38952 44884 53105 64725 81409
Growth 17% 15% 18% 22% 26%
Arch % of Rev 74% 70% 62% 54% 45%
Two important things come out here. First, the architecture segment diminishes rapidly in importance. Second, the total revenue growth rate is huge for a company this size. In this scenario, Intel still qualifies as a growth company, even at its current market cap.
Think those projections are too aggressive? Let's cut the growth rates in half, to 5%, for the architecture group, and 25% for other businesses:
2001 2002 2003 2004 2005
Arch ($mil) 28729 30166 31674 33257 34920
Other ($mil) 7379 9592 12470 16211 21074
Total ($mil) 36108 39757 44144 49469 55995
Growth 14% 10% 11% 12% 13%
Arch % of Rev 80% 76% 72% 67% 62%
Even in this less-optimistic scenario, double-digit growth continues and the architecture segment grows less important. Keep in mind, too, that this is just revenue growth -- Intel also has $14 billion in cash and $6.3 billion in long-term investments that are kicking off a decent chunk of cash every quarter. This level of income growth can support Intel's expected 20% long-term growth rate.
As of last week, Intel was going for about 29 times trailing free cash flow and 22 times 2001 estimates. It has a current P/E of 26. Shares in this longtime world-beater are quite affordable.
Intel still sits atop its core business. At the same time, it is expanding into related, higher-growth businesses. Its aggressive diversification effort benefits mightily from its cash horde. That cash is meaningless without know-how, of course. Fortunately, Intel has know-how in spades. It has one of the most forward-looking, intelligent management teams in the business. It also has a fantastic sales and marketing team (the blue guys in green paint notwithstanding). That is the foundation on which Intel will build its current and future business, and it's rock-solid.
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Bear Argument
By Rob Landley (TMF Oak)
I like Intel. I really do. I think it's a great company. But, it is in the middle of a painful business model transition and it's just not communicating its plans for the future clearly.
To find growth, Intel has to diversify. It has admitted this. It has been trying to do it. From Andy Grove's talks about the Internet as the new inflection point for Intel, to its initiative to become a Web-hosting company.
But, everywhere it turns to find growth, it also finds entrenched competition. Intel's Web hosting? IBM (NYSE: IBM) has a big head start in partnership with AT&T (NYSE: T) -- followed by every other Internet service provider on the planet. Internet connectivity through DSL? Cisco Systems (Nasdaq: CSCO) is there already -- as are a dozen highly determined smaller players. Flash Memory? AMD is there in partnership with Fujitsu (Nasdaq: FJTSY). Kingston is there. Hyundai is there. Samsung (Nasdaq: SSNHY) is there.
It's not that Intel can't successfully expand into other niches. It's that it can't hope to establish monopoly margins in any of the new areas I've seen. It's not king of the hill when it's on the road.
In the meantime, this growth is funded by its core business: making microprocessors. But Intel is having problems at home: "Intel inside" is no longer a given. I wrote a Rule Maker column about the Internet's impact on the PC, and the resulting shift in emphasis from "running software" to "connecting to the Internet." Despite the slogans in Intel's ads, a faster processor won't suck the Internet through a 56K modem any quicker. Even with a cable modem, a low-end Pentium can network Napster and Netscape at full speed. Extra memory helps this sort of thing more than extra processor speed.
When America Online (NYSE: AOL) teamed with Gateway (NYSE: GTW) to create an "Internet appliance," they picked a chip from Transmeta to run it.
These days, about all you really need top-of-the-line processor horsepower for is games, and again, a good accelerated graphics card is going to make at least as much difference. At any rate, the PC gaming market has been overtaken by consoles like PlayStation 2 (which uses a custom processor from Toshiba called the "Emotion Engine"). The video game market is bigger in dollar terms than Hollywood, which is why Microsoft (Nasdaq: MSFT) is trying to cash in on it with the X-box. ZDNet noticed consoles were a threat to PCs more than a year ago.
But, let's talk about Intel's core market. I spent a previous duel talking about how AMD's processors were taking market share from Intel. Intel is still fighting its partners over their support of AMD; for example, suing VIA for patent infringement because it makes chipsets for AMD. Micron's (NYSE: MU) trouble licensing Intel's P6 bus for its "Samurai" chipset led it to put that project on hold and instead create the "Mamba" chipset for AMD's Athlons, with eight megabytes of L3 cache embedded in the chipset, resulting in 50% lower latency and sustainable 9.6 gigabyte per second of memory bandwidth. (You may drool now.)
And, I spent a duel criticizing the pathetic morass of lawyers that is Rambus (Nasdaq: RMBS), whose current business model actually seems to be to sue the entire memory industry to extract royalties from a technology they didn't invent and don't even like. Literally. Intel has finally admitted that its relationship with Rambus was a mistake, but it is still contractually obligated to make the Pentium IV support it. Needless to say, Intel's engineers already said this (loudly and at length), and were shouted down by management. I won't say there was a little bad blood over this, but I will say the only Intel design engineer I knew at the time now works for VA Linux (Nasdaq: LNUX).
So, let's talk products. Intel has milked the P6 core for all it's worth, but when it tried to push it to 1.13 gigahertz it wound up with an embarrassing product recall. Intel's recent shrink to 0.13 micron copper manufacturing should help this, but AMD's Athlons already do 1.2 gigahertz at the larger 0.18 micron size. (Admittedly AMD did go to copper a year earlier than Intel, but how exactly is that a good thing for Chipzilla?)
So, Intel did the Pentium IV. I don't want to be too hard on the P4; most of the really new processor designs Intel introduces need a few versions to get up to speed. (From the Pentium 60 with the floating point bug that turned into a marketing disaster, and the operational temperatures you could fry eggs on, to the wildly successful Pentium Pro that just didn't like 16-bit code.) It's been through it before, it'll survive, but it's generally not fun.
The reason Intel did the Pentium IV was a technique software people like me call "Loop unrolling." One of the big limiting factors in a chip's clock speed is the ability to synchronize the signals traveling around the chip. The farther they go, the greater the margin of error for exactly when they arrive at their destination. A picosecond here, a picosecond there, it all adds up. The more complex the chip, the greater this uncertainty is, and the more of a delay you need to make it all work right.
The solution is "pipelining," or breaking each instruction down into tiny simple stages that can be arranged linearly along a wire. Figuring out how fast electricity flows along a straight wire is pretty simple, and the small circuits in each stage do as little as possible, so they can be clocked darn fast because there's very little confusion about when signals should be where.
The down side comes in when you have to reset the pipeline. With a 20-stage pipeline, a single instruction takes 20 clock cycles to complete, which is fine when you can have 20 instructions going down the pipe one after the other.
But, if you ever have to flush the pipe (cache miss, incorrect branch prediction -- the reasons are technical, but it happens), you have to restart the missed instruction that many more stages back along the pipe, and flush instructions in between that aren't valid anymore because they'd be executed in the wrong order.
So, the Pentium IV can be clocked way higher than a Pentium III or an Athlon, sure; but tests indicate that, in the real world, an Athlon or Pentium III outperforms it by around 25% at the same clock speed when running real software. The Athlon's clock speed looks to match the Pentium IV in the future. Not good for P4. Read more about that at Tom's Hardware Guide.
As for iTanium, go read the AMD duel. It's developed the nickname "iTanic," as in sinking without a trace.
In a day when Pentium III's inability to break the gigahertz barrier is reason to move on to new designs, iTanium is aiming for 800 MHz, and the systems Intel demonstrates at conventions are running at 500 MHz. I know it has 64-bit registers, but honestly, why bother?
On the bright side, rumor has it that Intel's second stab at a 64-bit chip, McKinley, has already taped out (which means the design was completed and sent to manufacturing, so they can start producing prototypes). So, Intel may actually have a 64-bit chip to sell by the time AMD does... assuming AMD doesn't deliver early. But, I still believe AMD has a better design (as explained in Rule Maker columns here and here).
Again, Intel isn't going to be driven out of the processor business anytime soon, but it faces real competition there, something it didn't have before last year. It's no longer a benevolent dictator. It's one among many, and diversifying won't change that. Intel's growth will be as much dictated by what its competitors do (in its core business and in the new businesses it's expanding into) as much as what it does. I think Intel can reach a new balance, but it's going to be a hard road getting there.
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Bull Rebuttal
By Brian Lund (TMF Tardior)
Oak has done a great job pointing out some trees, but he seems to be missing the forest. Intel certainly has struggled in the last year. It is facing renewed, reinvigorated competition from AMD. Its relationship with Rambus has proved costly, unproductive, and acrimonious. Its first 1+ GHz chipset, which was an ill-advised patchwork of RDRAM and SDRAM, wound up as an expensive and embarrassing recall. All in all, it has not been a great year for Intel.
But what has been the result of all these problems? Record revenues, even higher margins, and continued market dominance. If these are the bad times, I wish them for all the other companies in my portfolio.
Intel still has to respond to these challenges, no question, but I have no reason to think that it won't. Intel has a long tradition of countering adversity with success. Remember the problems Intel had with the first Pentium chip in 1994? How about the Pentium Pro issue that Rob cited? Don't feel bad -- neither do I. Intel's subsequent performance made those blemishes totally insignificant in the long run.
We're talking about a company that has spent $3.6 billion -- or about 82% of AMD's trailing 12-month sales -- on research and development. That's an increase of 36% over last year. You have to presume a lot of incompetence from Intel, a company with an incredible performance track record, to think that it won't soon have the technological as well as the business advantage again.
Of course, much of that R&D money is going into new ventures. Rob correctly points out that Intel faces competition with lots of established companies in these businesses. That's just fine. Intel recognized this challenge years ago and has met it head-on. It has the lead in flash memory and in some network components. Again, Intel has plenty of work ahead of it, but note that it made $5.9 billion in non-architecture revenue in the last year. That's 33% more than AMD brought in from its entire business.
If I thought that Intel had lost its innovative or competitive edge, I'd say that Rob is right to highlight Intel's recent mishaps. Thing is, I just don't see any reason to think that. Chairman Andrew Grove wrote the book on surviving through paranoia. Intel has the technological and managerial know-how to respond to adversity and compete with any company in the world. It has proven that time and time again.
Intel will be to the 21st century what General Electric (NYSE: GE) has been to the 20th. Founded in an important niche, it continues to innovate and expand. One day it will be synonymous with all computing and communications components. Will we remember then that the first version of the Pentium IV underclocked the Athlon?
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Bear Rebuttal
By Rob Landley (TMF Oak)
It's tough critiquing one of America's most profitable corporations, especially one I actually do like and own shares of. What's more, I agree with a lot of what Brian has to say. Where we differ is interpretation, and the emphasis we place on things.
Yes, Athlon's been out for well over a year and Intel processors still outsell AMD. The limiting factor here is production capacity. Both AMD and Intel are selling all the chips they can make, with a backlog of orders that's likely to intensify as the holiday season approaches and the start of a new corporate fiscal year opens the door to new purchases.
The amount of market share AMD can take away from Intel in the processor business is limited by how many chips AMD can make. AMD is investing profits (and the revenue from its secondary stock offering) to expand its production capacity.
But saying Intel's processor market share is secure because AMD is still growing is a hard argument to make, especially in an industry driven by the 18-month product lifespans indicated by Moore's Law. Intel's processor leadership in the future is no longer assured. Intel realizes this; that's why it's hedging its bets and diversifying into networking, site hosting, and such.
Sure, Intel's margins are still fine. They even grew last quarter, which isn't surprising when you realize that, for the first half of the year, Intel couldn't produce some of its most profitable chips (Gigahertz Pentiums) in volume. Hence prices (and thus, margins) didn't come down because of a supply-side squeeze -- ironically meaning AMD had no incentive to lower prices without competition from Intel! When Intel got its high-end manufacturing kinks worked out and supply normalized, the change in product balance overcompensated Intel's margins back above Intel's own often-repeated target of 50-55%. But, I won't be the first to point out that AMD has benefited from all this at least as much as Intel has: It was producing Gigahertz-plus Athlons at full speed the whole time, and still is.
When I say increased competition and lower prices, I'm talking about a shift in the industry, not next quarter. Increased volume can make up for the lower prices, but only for a company that manages to capture that volume, which fighting to stay at the high end of the market just won't accomplish.
I'm not saying anything Intel doesn't already know. I first discovered Clayton Christensen's brilliant book The Innovator's Dilemma (a New York Times bestseller that tops BusinessWeek's "Frequently Recommended Titles" list -- my review of it for the Rule Maker Portfolio is here) because Andy Grove brought it to the attention of Forbes.
It was also Grove who called the Internet an "inflection point," and bought time with the Celeron to diversify Intel's business away from the all-eggs-in-one-basket microprocessor-centric model. Again, I'm not saying anything that Intel hasn't already enacted plans to react to, I'm just noticing a lot of inertia involved when a company this size tries to change direction, complicated by the nature of the problem facing the company.
My argument isn't that Intel has something wrong under the hood, it's a question of steering the vehicle through the terrain ahead. Sure, I have plenty of technical nit-picks, but they're merely symptoms of the larger problem.
Things like the company's slow and halfhearted adoption of the ARM chip design for embedded devices. (Never heard of it? Here's an article from almost two years ago.) ARM is a low-power chip that can compete head-on with Transmeta's Crusoe in low-power performance, and is a natural in cell phones and other portable devices. It's a great asset to the company; if it really believes in the age of Internet access devices, this should be central to its strategy. But, does ARM get even 1% of the fanfare Intel puts behind the high-end iTanium? Nope.
As for Intel crippling its Celerons with a 66 MHz front-side bus (less than 1/10th the speed of the inside of the chip) so as not to compete with its own high-end Pentium III chips (leaving Celeron outperformed by AMD's Duron)... go read what Tom's Hardware Guide has to say about it. I have to shake my head and sigh for a bit.
The lure of high margins distracting a company from what it needs to do to secure its future is what The Innovator's Dilemma is all about. If you don't have time to read the book, go read the February 1999 Forbes issue that had Andy Grove on the cover with the book's author. The disparity between what makes the most money today and where the money will be coming from tomorrow is a powerful motivating force for a company to do the wrong thing. Like a smoker addicted to nicotine, the lure of existing customers and high margins can lead a company to unhealthy behavior. IBM couldn't switch from the mainframe market to the PC until its old market collapsed and dragged the stock down 75% in 1992. Digital Equipment Corporation (DEC) never managed to change, and was a pathetic shell bought by Compaq only a few years after celebrating its highest profits (and margins) ever.
Intel knows all this. It's trying very hard to prepare for the future. It's painful to see them know what the right thing is and then get distracted. The Pentium IV is aimed at systems selling for $2,000, when the selling price of midrange PCs has cracked the $500 mark and continues to sink. According to Moore's Law, that's two full generations away from the mainstream, assuming the mainstream stops drifting.
It does Intel no good to invade Sun Microsystems' (Nasdaq: SUNW) market if AMD eats into Intel's in the meantime. That's what did DEC in (chasing IBM's soft underbelly at the high end while Compaq was gobbling up DEC's core business). Silicon Graphics (NYSE: SGI) nearly went out of business over a similar debacle, distracting itself by buying Cray (Nasdaq: CRAY). Great companies all, by the way.
I'm here to remind everyone of the seven lean years, while the seven fat years are still here. Intel's trying to shape up for the future, but it's hard to nail your shutters closed in the eye of a hurricane when it's bright and sunny outside. Margins today are good, but they do not indicate what the future holds, and can easily distract you from it. Despite the sunshine, there is work to be done here. |
