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
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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