Barron's article Pt 1-Enjoy
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 to more 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.
Cover Story, Part 2
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