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Upbeat figures and manufacturing prowess can’t hide the trouble ahead for this tech giant

by Russ Mould

The bulls have latched on to Intel’s latest figures with considerable relief. The world’s largest semiconductor manufacturer met first quarter EPS estimates of $0.25, gently steered up second quarter gross margin forecasts and held its full-year guidance. The figures come against the background of a slump in sentiment toward the global technology stocks, after disappointing trading statements from industry leaders such as Oracle, Texas Instruments and ARM.

Even though the net result was a 1% increase in Intel’s second-quarter earnings forecasts, shares in the Silicon Valley giant shot up by 6% to $22.18 and helped spark a broader rally in London and New York.

Yet for all of Intel’s manufacturing prowess, history suggests management’s record of forecasting their own profits is no better than that of anyone else’s. Management had already cut first-quarter guidance in March, therefore reaching a lowered bar was hardly a great achievement.

Moreover, analysis of Intel’s quarterly results statements and mid-quarter trading updates since 2001 reveals the firm has missed or lowered its own guidance for group sales or gross margin 14 times and raised or beaten forecasts 14 times in the past 30 quarters, including the raised guidance for the current quarter.

That is a dismal record of earnings predictability, particularly from a company which has a near 80% share of its core microprocessor market. Yet this extreme volatility is easier to understand if the firm’s regular balance sheet publications are studied carefully enough.

Performance anxiety

Chart 1 shows year-on-year growth in quarterly sales, inventories and operating profits. High factory utilisation rates are key for Intel because the overheads from its hugely capital intensive business are enormous; Intel’s forecast depreciation charge in 2008 is forecast to be $4.4 billion, or a frightening $12 million a day. Accumulating inventory can help profit growth, as it helps Intel keep its fabrication facilities (fabs) heavily loaded. However, problems appear if inventory growth starts to consistently outstrip sales growth, as Intel eventually has to heavily discount on price to shift the excess stock, or slow production growth in its enormous fabs to prevent a further build-up of parts. Both steps inevitably hit profit margins.

Chart 2 compares quarter-on-quarter growth in sales and inventories against year-on-year profit growth. A 2006 downsizing programme saw Intel sell off its communications chips business to Marvell and launch a $2 billion cost savings programme. It also saw management tackle the record $4.5 billion inventory accumulated by the third quarter of that year. Inventory is now just $3.3 billion and, helped by some writedowns, Intel has now reduced its product on hand for four consecutive quarters – its best run this decade.

Similar progress in reducing inventory had been made by Q4 2002 and Q4 2004, when Intel subsequently produced a string of positive earnings surprises. Low stock levels and improving demand enabled the firm to crank up its new 300mm fabs and avoid hefty price cuts. The improved factory loading and better pricing drove up gross margins by 12 points in 2003 and 550 basis points in 2005, sending net profits soaring.

History repeating

If history is a guide, Intel could therefore be set fair in 2008. Yet the picture may not be as clear cut as it seems. In each of 2003 and 2005, profit momentum began to improve as soon as sales growth began to outstrip inventory growth, and also as the top line began to motor.

Intel may not have to discount heavily to shift stock, but the market share battle with chief rival AMD will continue, particularly as AMD has apparently fixed the bugs which delayed the launch of its Barcelona quad-core Opteron processor.

This year also looks set to offer much less helpful economic circumstances than either 2003, when the recovery from the tech bust was just beginning, or 2005, when the US and global economies were in full swing. The world’s largest PC distributor, Ingram Micro, the world’s largest motherboard maker, Asustek, and the world’s largest disk drive maker, Seagate, have all just issued profit warnings, suggesting PC demand growth is ebbing in 2008.

Most worryingly, Intel’s year-on-year top line growth decelerated to 9.3% in Q1 from 10.5% and 15.5% in the previous two quarters. Sales also fell faster than inventory did on a sequential basis. The creation of the Numonyx flash memory joint venture with STMicroelectronics will confuse sequential comparisons in the second quarter, but should inventory or receivables growth start to outstrip sales growth again, history suggests there could be further profit alerts later this year.