Intel earnings: Margins are the key to watch

Now that we’ve had a few hours to digest Intel’s fourth quarter 2006 earnings, here is what stands out. Overall, I’ll call it a major improvement for the chipmaker. A better end to a bad year. But there are still some trouble spots. Intel reported revenue of $9.7 billion, $1.5 billion in operating income and a net income of $1.5 billion, or profit, delivering earnings per share of 26 cents for the fourth quarter. This topped the Wall Street’s expectation for revenue of $9.44 billion and earnings per share of 25 cents.

The results represent strong sequential gains from the third quarter of 2006. That’s a good sign, given Intel’s less-than-spectacular results from the last four quarters. Thus it’s pretty clear that the company’s Core Microarchitecture products—the Core 2 Duo, Core Extreme, Xeon 5100 and Xeon 5300—are faring well, when the company can report record shipments. This is a positive sign for the company’s 2007 performance. However, when measuring its fourth quarter results on a year-over-year basis, Intel’s revenue, operating income and net income all showed significant declines. (Its fourth quarter 2005 revenue was $10.2 billion, with operating income of $3.3 billion and net income of $2.5 billion or 40 cents a share.) That means it still has work to do to please the financial crowd.

Overall, Intel’s results confirmed a lot of expectations, including showing that its its cost-cutting measures have been effective and that its inventory, which fell for the first time since 2005, is heading in the right direction. That meant the one thing that stood out the most from the results and the ensuing conference call, hosted by Intel CEO Paul Otellini and CFO Andy Bryant, was the competitive environment in the fourth quarter. AMD’s fourth quarter earnings warning, last week, signaled that pricing would be an issue for the two chipmakers’ fourth quarter financials. Alas, it was.

Despite reporting higher processor selling prices during the quarter, Intel’s gross margin missed forecasts and came in at less than 50 percent for the second consecutive quarter. Its fourth quarter gross margin was 49.6 percent, up from 49.1 percent during 3Q06, but well below the fourth quarter of 2005’s 61.8 percent. The year-to-year decline in the figure, which basically represents what’s left after the costs of manufacturing a product are accounted for, shows that Intel faced intense pricing competition from AMD. Otellini and Bryant indicated during their call that the competition in the desktop processor market was particularly intense. They said Intel’s desktop unit shipment growth actually came in below seasonal trends—which normally sees a unit shipment increase of around 10 percent—which probably made the situation more difficult. Intel make up the deficit by shipping what it says were record numbers of notebook and server processors in the quarter.

The executives said they don’t expect the competition to let up in the first quarter. Clearly, it will not as the chipmakers fight for market share. AMD wants to keep what it has earned over the last two years. Intel wants it back. This battle will put pressure on both companies as the profit on each ship they sell will be reduced. Intel, for example, forecast its 2007 average gross margin at about 50 percent. Historically, it’s been closer to 60 or 65 percent.

For consumers, the price competition will means good deals, whether on boxed processors or on finished PCs. There, it’s likely that PC makers will use lower processor prices to shoehorn higher-end processors into lower-priced desktops.

To help it become more competitive, Intel has cut costs considerably with its so-called efficiency program, which includes 10,500 job cuts and jettisoning non-essential businesses. The company’s SG&A—or selling, general and administrative expenses, the bulk of which is typically salaries—dropped to 14.8 percent of revenue in the fourth quarter, for example, and its down significantly from 19.9 percent in the second quarter of 2006. The program cost Intel a one-time restructuring charge of $457 million for the fourth quarter. But, going forward, the efficiency program appears on track to boost the company’s profitability.