A Pause in the Chip Recovery
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Intel's glum earnings show that sluggish PC sales are doing nothing to boost demand. That will come, but not soon
On Oct. 15, Intel (INTC ) failed to meet Wall Street's expectations for its third-quarter results. The bellwether chipmaker's miss was pretty clear. It earned 11 cents per share (before 1 cent per share related to acquisition charges), which was below the Street's consensus forecast of 13 cents per share. The problem was gross margins, which came in at 49%, at the low end of a guided range of 51% plus or minus two percentage points.
Revenue came in at $6.5 billion, which matched Intel's Sept. 5 outlook for a bit below the midpoint of between $6.3 billion to $6.9 billion. Revenue was flat year-over-year and, disappointingly, rose only 3% from the second quarter in a period that typically shows more seasonal strength. Overall, the story is that PC demand did not pick up much, market share gains against Advanced Micro Devices (AMD ) in processors helped a little, and a failure to reduce factory operating costs as much as expected led to a glum report.
RALLY-STOPPER. Intel's results helped squelch a strong four-day stock market rally on Oct. 16. It was the main headliner that day, helping to drag the Philadelphia Semiconductor index (known as SOX) down 8.8% and the Nasdaq down 50 points, or 3.9%. Intel fell nearly 3 points, about 18%, to $13.54 that day. The commotion serves as a reminder of chip stocks' volatility, and we at S&P think investors should consider the industry to be more of a speculative trading play than a long-term holding.
Compounding Intel's misery was the dour outlook for the December quarter, which usually sees a good seasonal lift. Intel expects just $6.5 billion to $6.9 billion in revenue. The midpoint of this range represents another anemic 3% quarter-over-quarter rise, vs. the 10% growth possible in a strong economic environment. Even worse, Intel sees gross margins of 49%, plus or minus 2%, implying no improvement from the third quarter.
Analysts slashed estimates for Intel's 2003 EPS to about 60 cents from a prior consensus near 73 cents. Keep in mind that this tech company pays some portion of compensation via stock options. This reduces the quality of earnings by creating a lingering likelihood of dilution or perhaps a cash cost to buy back worthless stock options from employees, as has been the case with Siebel (SEBL ) and Nvidia (NVDA ).
As a rule of thumb, I suggest that individual investors consider knocking 5% to 15% off earnings estimates for tech stocks with significant options exposure before comparing their earnings with outfits in other sectors where compensation via options isn't as prevalent. The impact of stock options for Intel's EPS in 2001 was 15 cents, as estimated under the SFAS accounting rule 123.
CONFLICTING CURRENTS. We at Standard & Poor's cut Intel's EPS estimates to a projected 48 cents, down from 52 cents, for 2002. We estimate 60 cents for 2003, down from our prior estimate of 75 cents. (We do not have a formal estimate for stock options expenses but suspect it would be lower than the 15 cents per share estimated under the accounting rules for 2001.) We also downgraded our recommendation on Intel shares to avoid, from hold, and we expect the stock to lag behind the broader market over the next 6 to 12 months.
Intel is faced with a classic problem in a cyclical industry: making the right amount of cuts in production capacity during a downturn. It needs to reduce plant activity to bring costs down to match the lower revenue levels. But Intel is reluctant to make deep cuts because it will have to pay for layoffs and mothball plants. And if a company cuts production too far, it could risk missing sales if there is a sudden rise in demand. So Intel tends to carry excess capacity if management thinks an upturn will come soon.
However, overall semiconductor sales haven't improved as quickly as anticipated. Sales for 2002, in S&P's view, are expected to be flat to up 3%, to roughly $143 billion, from $139 billion in 2001. But that's down significantly from peak sales of $204 billion in 2000. The Semiconductor Industry Assn. (SIA) sees chip sales growth of around 20% in both 2003 and 2004. In light of the growth pause since the summer, S&P suspects that the SIA might lower its 2003 estimate to the high teens but leave its 2004 growth forecast near 20%, when the SIA updates its forecast on Nov. 6.
ANOTHER BLEAK YEAR? For Intel, an attempt to diversify into communications chips to reduce reliance on the PC markets is going to be difficult. Wireline chip markets are moribund, although wireless markets are showing signs of life. This means Intel continues to rely mostly on the health of PC-related chip sales, which tend to be weaker in the first six months of the year. Intel's admission that sales growth is apt to be very modest in 2002's second half indicates it may face another full year of weak sales growth before a possible surge in PC sales kicks in.
Sales aren't coming back in a manageable timeframe for the amount of capacity Intel kept up. It's still working through some cutbacks, including staff reduction of 4,000, announced last summer, but Intel might cut more jobs if sales forecasts turn lower. The big question is whether the next PC upgrade cycle will be delayed from late 2003 to late 2004 as consumers hold on to their old machines.
Also, many corporations have put off hiring -- and the PC purchases that come with it -- until the economy strengthens. But by the second half of 2004, the PCs purchased for Y2K compliance in 1999 will have become decisively obsolete, and the economy should be in much better shape.
The real turning point for chip companies, though, should come when demand finally starts to exceed capacity, sending average selling prices (ASPs) of chips higher. These remain quite weak, falling to a low of 37 cents in April, 2002, from a high of 59 cents in September, 2000. ASPs improved slightly to 41 cents in August, 2002, according to the most recent data from SIA.
SLOW TO MEND. With both corporate and consumer purchasing of electronic equipment soft, and a lack of any new "killer applications" to drive new sales, ASPs are likely to stay depressed until demand for tech hardware picks up. S&P figures chip pricing could improve as early as the middle of 2003, in an optimistic scenario, but 2004 is more likely. If the economy weakens significantly, the next chip boom may be pushed out to 2005.
The uncertainty surrounding the exact timing of a chip recovery has made it difficult for investors to determine a good time to buy the beaten-down shares. There's no question that many semiconductor stocks have been driven down to cycle-bottom valuations. Some issues have even slipped past prior cycle bottoms to new lows on a price-to-book measure amid the latest negative news.
Valuation alone isn't a good enough reason to jump into chip stocks now. S&P recommends underweighting the information-technology sector, considering the lack of IT spending. And though investors tend to buy chip shares 12 months or so ahead of a fundamental turn for the industry, we think it's still too early to make that bet.
Analyst Smith follows computer hardware and semiconductor stocks for Standard & Poor's
Edited by Karyn McCormack
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