How Intel Earns Real Profit From Mobile

Aug.27.14 | About: Intel Corporation (INTC)

Summary

Intel continues to gain more mobile design wins.

Based on expense recognition criteria, volume ramp will have a significant impact on gross margins and gross profits.

Assuming Intel reaches 40 million in shipment volume, the mobile segment's gross profit figure will improve significantly.

I anticipate Intel to earn profit from mobile devices in fiscal year 2016.

Editor's Note: This article has been updated to reflect reader feedback.

Intel (NASDAQ:INTC) is making its push into the mobile market, and initial supply chain data points to a positive trajectory. Cherry Trail, which is Intel's upcoming mobile SoC platform, will come with performance gains across modem, CPU and GPU in a SoC package. The extent to which performance improves isn't completely known until we see performance figures from Intel's upcoming developer forum, but until then, it's fair to assume based on the mobile wins reported by Digitimes, Intel is on the right track.

According to Digitimes:

Intel is aggressively cooperating with Taiwan and China-based tablet players, looking to push its tablet processor shipments to 25 million units in the second half of the year in order to achieve its annual shipment goal of 40 million units, according to sources from the upstream supply chain. Intel shipped less than 15 million tablet processors in the first half of the year.

So, I guess Intel is starting to climb itself out of the admittedly deep hole that was created from the contra-revenue arrangements that have cost Intel up to $2 billion. Sounds similar to Microsoft's (NASDAQ:MSFT) surface story, but because it's Intel, the technology community gives Intel a pat on the back for at least attempting to compete with Qualcomm (NASDAQ:QCOM).

But really, in the case of Intel, what is contra-revenue? Well, the terminology gets thrown around a lot, so part of the operating loss is driven by sales discounts to OEMs, whereas another component is the R&D expenditure that's applied to the specific segment. The supplemental data is a mix of financial/managerial accounting principles, where it lays out specific cost recognition for a category that didn't generate much in terms of sales, but had ongoing op-ex and elevated levels of cost of revenue. But more specifically, the depreciation expense seems to apply to cost of revenue, and since Intel runs on a fab model, it has to apply depreciation expense across all of its reporting segments on a per wafer basis.

According to Intel (page 110):

Based on the interchangeable nature of our manufacturing, and assembly, and test assets, most of the related depreciation expense is not directly identifiable within our operating segments as it is included in overhead cost pools, and subsequently absorbed into inventory as each product passes through our manufacturing process.

So each product that Intel sells carries depreciation expense for mobile/tablet handsets, and since mobile also has operating costs, the burn rate from the segment is pretty significant.

Going forward, the cost of goods sold will decrease on a per unit basis, as volume ramps. This is where gross margin improvements will come into play when it comes to both the tablet and mobile segment. However, they do a really wonky job of explaining it over the conference call.

Brian Krzanich on Q2 earnings:

We are on schedule for our 40 million. We did 10 million in Q2, so we did roughly 5 million in the first quarter, 10 million in the second quarter. We did say that we would continue to drive down our cost and hence the contra revenue. We're continuing to do that. Bay Trail adds to that capability. As we exit this year we said they were on schedule with SoFIA. SoFIA is a fully integrated part really designed for this segment. That allows us to move into 2015 with a much, much better cost structure and really drives down the contra revenue to near 0 on those products.

In fiscal year 2013, Intel had $6.8 billion in depreciation and amortization-related expenses. The costs will apply to mobile wafers, paired with ongoing R&D expense, plus promotional activity with OEMs. So, I sort of hope that makes sense.

Okay, so since profitability is heavily contingent upon volume ramp, let's move onto the architecture that's gaining acceptability from various OEMs.

According to Anandtech:

Looking to the future, the platform that may finally give Intel a real leg up on the competition likely won't come out until early to mid 2015. That's the Cherry Trail platform, which will upgrade the CPU cores to Airmont and move to Intel's 14nm process, delivering better performance in a lower power package. We've been saying "wait for the next Atom update" for a while, but on paper at least Cherry Trail looks very promising - it's the first Atom to ship on Intel's latest process technology without waiting a year or more, and it's the second Atom design after Intel's commitment to begin updating the Atom platform on a yearly basis.

So, according to technology experts, it's likely that Intel's upcoming mobile solution for 2015 will move the needle in terms of revenue. This coincides with the CEOs comments of gaining mobile OEMs, and supply chain sources revealing that Intel is on track to meet its 40 million annual shipment goal over the next two quarters.

In fiscal year 2015, I anticipate shipment volume to ramp even further, which will offset cost of revenue/and operating costs applied to the segment. This will cause gross margins on a consolidated basis to trend even higher than what analysts may be anticipating.

In summary, investors should anticipate Intel's mobile segment to report profit on an operating basis in fiscal year 2016, but if we're lucky it may happen in 2015. (I will work out the math on this in a future article.) I continue to reiterate my buy recommendation.

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