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Contributors: Douglas McIntyre Jon C. Ogg

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Wednesday, October 18, 2006

Intel: Still Making Too Many Chips

After Intel (INTC) reported their results yesterday, investors appeared relieved that the company signaled that the price war with AMD (AMD) is cooling off.

“What’s good about Intel is that they’re pointing to sequential growth on the topline and are also pointing to a 100 basis-point increase in gross margins,” said Ray Rund, managing director of Shaker Investments.

Still, the modest after-hours rally was not enough to make up for the hit taken during the day following a downgrade by Goldman Sachs.

The broker told clients that while it thinks consensus expectations are too aggressive heading into the quarter, its downgrade is based solely on valuation as the stock has reached its $22 price target. Goldman said it expects Intel to gain market share and execute on cost reductions in 2007, but believes this is now largely priced into the stock.

We think the muted rally was justified, as it looks to us as though things haven’t gotten all that much better. The earnings release showed another sequential rise in inventory, which now stands at $4,477 million (up from 4,332 at the end of the second quarter.) Although inventory did not rise as much as sales did sequentially, it is one thing to reduce inventory by selling it and quite another to reduce it by throwing it away:
The gross margin percentage was consistent with the company’s expectation in July as the impact of higher microprocessor revenue was offset by a write-off of older processor inventory of approximately $100 million.

Furthermore, while the sequential rise in sales was better than the rise in inventory, the year/year comparisons are much less favorable. Sales declined more than 12% compared to Q305 while inventories balloned by 59%! So while the modest quarterly improvement is somewhat encouraging we are not yet ready to call an end to Intel’s woes.

Likewise we are not impressed by the projected improvement in gross margins. Since the margins this quarter included the $100 million writedown, just removing that is good for 100 basis points. Why not write down even more so we can get a 500 basis point “improvement” next quarter? Furthermore, since the marginal cost of semiconductors is near-zero producing more will result in higher margins (until the quarter you have to write them down.) So it sounds to us as though they are just giving us more of the same.

One potentially positive signal was their guidance for capital expenditures:

Capital spending for 2006: Between $5.7 billion and $5.9 billion, lower than the previous expectation primarily due to greater equipment reuse, productivity improvements and small timing changes.

We have said over and over and over that the way for Intel to get out of the doldrums is to produce only as many chips as they can sell. Reducing their purchases of manufacturing capacity is the way to do that. However, even here we are a bit concerned that the message hasn’t sunk in because the “small timing changes” indicates that they moved some planned purchases for the fourth quarter into early next year. It’s a start, but if the next earnings release discusses “large timing changes” we’d be happier still.

The author may hold a position in the securities discussed. A current list of the author's holdings is available here.

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