Memo To Intel Bulls: PC Supply Chain Worse Than It Looks

| About: Intel Corporation (INTC)

Intel (NASDAQ:INTC) bulls must acknowledge the idea that Microsoft Windows is the primary engine driving the PC supply chain towards the end consumer. As such, the PC supply chain is always at risk for major bottlenecks at key junctions, if consumers refuse to open up their wallets and purchase computers running Windows software. In actuality, Microsoft (NASDAQ:MSFT) and Intel financial results are lagging indicators, because these companies hawk the majority of product to businesses and original equipment manufacturers, such as Hewlett Packard (NYSE:HPQ). The latest Windows 8 software upgrade effectively forced hardware companies to pay tribute to Microsoft and Intel, simply to stay current. The real damage will not appear upon Intel financial statements, until unwanted Windows 8 machines pile up in the Best Buy (NYSE:BBY) bargain bin immediately following the 2013 Holiday Season.

Windows 8 and 8.1

Microsoft launched its Windows 8 operating system on October 26, 2012. At the time, Windows 8 was the first major operating system upgrade out of Microsoft since Windows 7, which was released three years prior. As such, the Microsoft marketing machine and its associated parties mobilized fully to promote Windows 8 as a "revolutionary" platform. Microsoft executives presented Windows 8 as an integration of typical personal computer, tablet, and smartphone interfaces beneath one software umbrella. Last September, Intel rolled out its Bay Trail chips, which were designed specifically to power Windows tablets. Intel refers to Windows tablets as "two-in-one" machines that offer traditional tablet and laptop capabilities.

Windows 8 emerged as most notable for its touch screen interface and conspicuous lack of the Start Menu. The Windows 8 movement apparently began as an attempt to be all things to everybody that ended up pleasing nobody. Woody Leonhard of Info World and Dan Rowinski of Tab Times both dismissed Windows 8 as a "boondoggle." Rowinski went on to rip Microsoft as an "arrogant tech company that believe it should succeed just because it put a lot of work into a product and threw a lot of money behind it." The Windows 8 operating system was also written off as "slow" and a "marginal competitor."

Enter Windows 8.1. Windows 8.1 has been slated for launch on October 18, 2013, almost one year after the initial Windows 8 release. Upon launch, existing Windows 8 users can upgrade to Windows 8.1 for free. Brad Chacos and PC World have already described Windows 8.1 as "The Great Compromise." Windows 8.1 was designed as a play more so to accommodate traditional PC users, rather than herding them into modern tablet interfaces. For Windows 8.1, Microsoft has installed boot-to desktop alongside a Start button that does feature Shut Down and Restart commands. This Start button, however, directs users towards modern tile prompts, rather than the standard desktop shortcut files of the traditional Start Menu. Still, Chacos railed against Windows 8.1 as a "tablet interface mashed together with a desktop user interface." Despite noticeably smoother transitions between applications, new Microsoft software lacks a clear identity.

PC Supply Chain Bottleneck

A brief overview of Intel's latest 2012 annual report has presented a broad and clear image of the chipmaker's place within the PC supply chain traffic bottleneck. Be advised that Intel fiscal years have largely coincided with calendar years. For 2012, Intel classified its businesses according to PC Client, Data Center, Other Intel Architecture, and Software and Services operating segments. Other Intel Architecture accounted for mobile chip sales, which have recently ranged between 7% and 9% of revenue at Intel. On average, the PC Client Group has generated two-thirds of Intel annual sales, over the past three years. Even more specifically, Hewlett-Packard, Dell (NASDAQ:DELL), and Lenovo were the top-three customers at Intel, as they combined for more than 40% of 2012 revenue at the company.

On August 21, 2013, Hewlett Packard released a financial report for its third quarterly period ended July 31, 2013. Year-over-year Hewlett-Packard earnings comparisons between 2012 and 2013 were greatly distorted due to the massive $20.7 billion worth of asset write-downs and charges taken in 2012. In terms of revenue, Hewlett-Packard has tallied $83.2 billion in sales through the first nine months of fiscal 2013, which was an 8% decline off the year-over-year 2012 mark on $90.4 billion. Broken down further, revenue out of HP Personal System, Enterprise Group, and Enterprise Service divisions all fell significantly over the past 12 months. HP Personal System revenue deteriorated from $8.6 billion to $7.7 billion between 2012 and 2013. In her 2012 letter to HP shareholders, CEO Meg Whitman already intimated that this company would aggressively cut costs, as part of its restructuring efforts. Intel shareholders should expect HP to slash its cost of goods sold, streamline inventory, and cancel chip orders, as revenue here continues to falter. The results at Hewlett-Packard are the canary in the coalmine for the PC supply chain at large.

All recent reports out of research firm Gartner have confirmed that the global personal computer market has contracted sharply. On July 10, 2013, Gartner estimated that worldwide PC shipments declined by 10.9% between Q2 2012 and Q2 2013. The next month, on August 7, 2013, Gartner indicated that the consumer PC market in Western Europe had collapsed by 25.8% during the same year-over-year time frame. According to Meike Escherich, Gartner principal research analyst, Windows 8.1 and Intel Haswell processors "will not fully compensate for the ongoing PC decline." By all accounts, the news did not bode well for the long-term prospects of Intel shareholders.

The Bottom Line

On October 4, 2013, Intel stock closed out the trading session at $22.81 per share. Shareholders then owned part of a company worth nearly $115 billion in market capitalization, or 10.5 times 2012 trailing earnings. Going forward, however, Intel may struggle to finish up the 2013 year with $8 billion in net income. This performance would value Intel near a relatively expensive 15 times current earnings. This valuation is too expensive of a price to pay for a company where executives wearing rose-colored glasses once projected "single-digit revenue growth" through 2013. Ironically, Intel has gone in the opposite direction, with a single-digit 3.8% revenue decline through semi-annual 2013.

Intel has made the commitment to dump cash into research and development spending, despite the fact that revenue has declined over the past 18 months. The aggressive stance towards R&D spending dovetails with Intel talking points to emerge as a player within the mobile chip market. Intel bulls must read between the lines and also acknowledge the idea that this company is attempting to branch swing into mobile, as the PC market further deteriorates towards the point of no return, in terms of achieving real growth. Intel, of course, is not likely to recover much ground against entrenched Qualcomm (NASDAQ:QCOM) and ARM rivals within the mobile chip market. ARM is in the business of licensing out patent technologies, while Qualcomm farms out chip manufacturing to outside subcontractors. Intel owns its foundries, which would mean that volume is necessary to counteract the fixed costs of production.

Ironically, Intel shareholders are effectively forced to deal with the Catch 22 of both Moore's Law and the Law of Large Numbers. Success for Intel in mobile would actually drive down margins at the company. The Intel business model is boxed in from all directions and the stock is a strong sell.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.