Semiconductor giant Intel (NASDAQ:INTC) reported better-than-expected fourth quarter results. Revenue declined 3% year-over-year to $13.5 billion, roughly in-line with consensus expectations. Earnings easily exceeded modest estimates, falling 25% year-over-year to $0.48 per share.
Due to the weak PC market and the firm's desire to clear inventories, gross margins were down significantly in the fourth quarter, falling 650 basis points year-over-year to 58%. Gross margin declines were the primary driver behind the lapse in profitability, but research & development costs increased $300 million compared to the same period of 2011 to 19.5% of sales (up 290 bps Y/Y).
On a segment basis, the PC Client Group, not surprisingly, drove the majority of revenue weakness, as Intel's largest segment experienced a 6% decline in revenue to $8.5 billion. Profitability suffered even more, falling 29% year-over-year to $2.8 billion. It goes without saying that the PC market was weak in 2012, but we think some new product introductions such as all-in-one computers could spike interest in PCs going into 2013. Windows 8 hasn't been the success Microsoft (NASDAQ:MSFT) promised it would be, but its touch interface still has the potential to gain some market share.
Data Center Group revenue ticked up 4% year-over-year to $2.8 billion. Gross margins were about equal to the previous year, but the company has been investing heavily in increasing capacity for its cloud services. We think a 4% growth rate, while not the double digit growth we saw in 2011, is a solid figure considering the broader economic landscape. Not only was the global macro outlook choppy, but the US was dealing with the fiscal cliff fiasco that resulted in a hiring and investment freeze. Regardless, CFO Stacy Smith provided some positive commentary on the conference call heading into 2013:
"…we expect the data center group to return to double-digit revenue growth and diving into that, it's the cloud data center plus our participation in portions of the market like storage and some of the networking sections of the market. It's both unit and ASP based on the strength of our product line and follow-up."
Software and Services, driven primarily by McAfee, grew 10% year-over-year to $600 million. Several "old" tech companies such as Dell (NASDAQ:DELL) and HP (NYSE:HPQ) are focusing on becoming software-driven enterprises, but we do not think Intel has to follow the same path. Its current hardware offerings are less commoditized and are more of a value-add thanks to the company's manufacturing prowess.
Speaking of manufacturing, the company recently landed a deal with Cisco (NASDAQ:CSCO) to produce made-to-order networking chips at its foundries. Intel is lauded for its manufacturing excellence, and we like the move as a way for Intel to diversify away from the PC business. If the deal proves to be a success, Intel's foundry business could add solid incremental revenue growth.
Still, all eyes remain locked on the company's decision to elevate capital expenditures and operating expenses in 2013. The company forecasts low-single-digit revenue growth in 2013, but operating expenses will increase 4%-6%, to $18.9 billion, and capital investment is expected to come in at $13 billion. Much of the elevated level is due to investment in brick-and-mortar facilities and capacity expansion, which we believe, will not be recurring once completed. In 2013, this could pressure earnings, especially if margins remain subdued (forecasted at a flattish 60%). However, the company's decision to raise debt and likely repurchase stock should mitigate some of the earnings per share impact. Further, given departing CEO Paul Otellini's and Stacy Smith's solid track record of capital allocation during their time at the helm, we have faith that management is making solid investments for the future.
We think it's important to remember how transformative building a great mobile business could be for Intel. Apple (NASDAQ:AAPL) wants nothing more than to replace Samsung in its existing iPhone package, but it won't change suppliers until a new company makes a better chip. Over the past several decades, Intel has shown that it's more than capable of building the best chip in the industry. If Intel is able to create the pre-eminent mobile chips, we think other industry players such as RIM (RIMM) and Google's (NASDAQ:GOOG) Motorola Mobility would consider more extensive relationships.
Overall, we at Valuentum thought the fourth quarter was stronger than anticipated, and we believe guidance for 2013 is decent and conservative. Revenue in the first quarter is expected to be $12.7 billion plus or minus $500 million, with gross margins remaining relatively low at 58%. With the Street largely disappointed in the higher levels of investment, we could see shares pull back materially yet again. However, we think plenty of upside remains, with several potential catalysts in 2013 and the first half of 2014. Though price action has been disappointing, fundamentals remain solid.
Additional disclosure: Some of the firms mentioned in this article are included in our actively-managed portfolios.