1 Step Backward, 2 Steps Forward For Intel

| About: Intel Corporation (INTC)

Summary

INTC dropped nearly 6% after lower than expected growth in the company’s data-center products division’s operating profit.

The results are due to costs associated with updating manufacturing technology, an infrequent but expensive part of the development cycle.

Once manufacturing yields are up and cuts are made to R&D, the company can reap the profits of its recent investments.

Intel (NASDAQ:INTC) announced its Q3 2016 earnings on Tuesday (18 Oct) after the bell. Despite beating expectations by $0.07 per share, lower than expected growth in Intel's enterprise data-center product segment caused a selloff on Wednesday, closing down nearly 6% to close the day at $35.51. Intel cites heavy investment in new 14nm server microprocessor architecture, which offers "tremendous opportunities" according to Executive Vice President of Manufacturing, Operations and Sales Stacy Smith, as well as planned growth in operating expenses associated with the new architecture as the cause for the decline in expected growth. Data Center revenues did grow 10% year-over-year, however, the profit margins fell from 51.45% to 46.46%, or $2.13 billion to $2.11 billion, respectively. Investors didn't seem to look at things quite the same but a deeper look into the company's comments and other businesses may lead to some reconsideration.

14-Nanometer Production Isn't Cheap, Yet.

During the last few quarters, we've seen Intel introduce chips based on designs utilizing 14nm transistors as opposed to the previous 22nm designs which it is slowly but surely phasing out. In case you were wondering, the term "14-Nanometer" describes the lithographic length, or the degree of precision in each fabrication. It determines how precise etchings can be on a silicon wafer and what the number physically describes ultimately depends on the number of parallel points on each transistor. The technology allows Intel to place more processor cores in each chip, leading to an increase in performance as well as reduced power consumption.

While the physical difference between 14nm and 22nm may seem negligible at first, the costs of manufacturing technology for 14nm chips is significantly higher than its predecessor. Intel has yet to manufacture and sell enough of the new chips to match the manufacturing yields of the preceding technology. As time goes on, manufacturing yields will mature and manufacturing costs will be reduced. Intel is in a competitive market with realistic expectations of losing market share in the segment to the likes of AMD (NYSE:AMD), IBM (NYSE:IBM) and even new entrants to the market such as ARM (NASDAQ:ARM). Investors are looking for a quick rollout but Intel's mentality is more in the camp of slow and steady wins the race.

PC Profits Have Surged

One part of Q3 earnings that stood out for the company were PC microprocessor sales, which fall into the company's Client Computing Group (CCG). Operating profit in the segment grew 36.7% leading to over $3.327 billion in profit. The number is important. It's a key figure investors have been looking at since Q3 2015 when the group reported $2.433 in profit, a plunge from Q3 2014's $3.053 in profit. The company attributes the growth to increased revenues, lower product costs and lower investment levels. Revenues for the quarter increased to nearly $8.9 billion from $8.5 billion year over year.

The company had transitioned its CCG products to the newer 14nm manufacturing technology last year to meet the demand for faster and more energy-efficient desktop and notebook CPUs. With stiff competition in the segment, raising prices wasn't an option, so Intel's gross profit margins fell resulting in the plunge in Q3 2015 operating profits. With increased production and sales of 14nm chips, manufacturing yields ultimately drove down operating costs and increased operating profits while also reducing costs in consumers. It is important to note, however, that the group had its investment levels cut by management at the beginning of Q2 to shift investments into data-center products which have been growing quickly due to the increased popularity of cloud computing, among other things. The move comes as investments in 14nm technology have begun to pay off for CCG.

Can Data-Center Go The Way of CCG?

The company has decided that it's time to reap previous investments in 14nm tech for PC and notebook products. In order to do so, drastic cuts to CCG's research and development were made which lead to a great quarter but a repeat of such an increase in operating profit isn't likely going forward given the unlikely possibility of personal computer sales increasing or operating costs being cut further. Intel's personal computer products are offered in a variety of price ranges and performance capabilities. CCG is competitive for the near future and will continue to profit off 14nm technology implementation. Once enterprise data-center consumers begin to get their hands on more 14nm Intel products, operating yields will likely increase while investments in the business are cut for the short term. Revenues still grew 10% in the data-center segment in a market that is continuing to grow. The 14nm server chips are likely to sell well as they provide both performance and cost-efficiency boosts for IT departments. Year-to-date, INTC is up roughly 7%. The stock plunged nearly 6% after lower than expected growth in data-center products operating profits. However, the drop has been attributed to costs associated with the more expensive portion of the development cycle - updating highly-technical and highly-expensive manufacturing technology. The company is poised for growth in that segment and any future indications of a strong fourth quarter could test, or even break, the 52-week high of $38.36 set right before Q3 earnings.

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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.