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Intel Corporation (NASDAQ:INTC)

Q2 2007 Earnings Call

July 17, 2007 5:30 pm ET

Executives

Paul Otellini - CEO

Andy Bryant - CFO

Kevin Sellers - IR

Analysts

Glen Yeung - Citigroup

John Lau - Jefferies

Michael Masdea - Credit Suisse

Chris Delaney - JP Morgan

Hans Mosesmann – Moors & Cabot

Sumit Dhanda - Banc of America

Joseph Osha - Merrill Lynch

Uche Orji - UBS

JoAnne Feeney - FTN Midwest

Tim Luke - Lehman Brothers

Cody Acree - Stifel Nicolaus

Brian Piccioni - BMO Capital Markets

David Wu - Global Crown Capital

Ross Seymore - Deutsche Bank

Krishna Shankar - JMP Securities

Presentation

Operator

Good day, ladies and gentlemen and welcome to the second quarter 2007 Intel Corporation earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. Kevin Sellers, Director of Investor Relations. Please proceed, sir.

Kevin Sellers

Thank you, Melanie and welcome, everyone to Intel's Q2 2007 earnings conference call. As we begin our call, let me remind you of some of the important information about our earnings that are posted on the investor website, intc.com.

First, we posted our earnings release and updated financial statements on the site for anyone who still needs access.

Second, a replay of today's call will be posted there at around 5:00 Pacific time and will remain there for approximately two months.

Lastly, if during this call we use any non-GAAP financial measures or references, we will post the appropriate GAAP financial reconciliations there as well.

Joining me on today's call are Chief Executive Officer Paul Otellini and Chief Financial Officer Andy Bryant. Paul will be reviewing the highlights of the quarter and add some commentary on the company's execution. Andy will then provide more details on our financial performance in Q2 as well as the business outlook for the second half. Following Andy's comments, we'll be happy to take questions.

As we begin, let me remind everyone that today's discussion contains forward-looking statements based on the environment as we see it today and as such does include risks and uncertainties. Please refer to our press release for more information on the specific risk factors that could cause actual results to differ materially.

With that, let me hand it over to Paul.

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Paul Otellini

Thanks, Kevin and thank you all for joining us today. In Q2, Intel delivered another quarter of solid financial results, reflecting both our product and technology leadership and continued gains in our operational performance. Orders strengthened and revenue came in above the midpoint of our expectation.

In addition, our restructuring efforts led to strong growth and operating profits which were up 26% from a year ago. We are particularly pleased with the execution of our factory network, which continues to deliver world class yields, lower unit costs and faster throughput times.

While demand for computers was strong, pricing remained competitive, notably in the low end of the PC marketplace. Our technology leadership did give us relative stability in the server and performance notebook categories, however. Let's take a minute to review the business in our major product areas.

In servers, we continued to see strong acceptance of our Xeon Quad Core processors as unit shipments doubled in the second quarter. We have now shipped over a million Quad Core server processors since our November launch. In total, our server units and revenue were up by double-digit percentages both sequentially and year over year. Later in the third quarter we will bring the benefits of our core micro architecture to the MP segment for the first time with the launch of our Caneland platform.

In mobile, revenues were up by more than 20% year over year. We launched our Santa Rosa platform, which has more than 230 design wins around the world and continues to ramp quickly. Mobile represented 40% of our client shipments in Q2 and we will continue to benefit from the market shift to mobile in the second half.

Desktop unit demand came in higher than seasonal with strength across the board while revenue was lower on a year-over-year basis. Intel's channel business remained strong and grew in a seasonally down quarter, ending the quarter with inventories that were lower and well within our goals. We also launched a new desktop version of the Core 2 Extreme yesterday, marking the introduction of Intel's 14th Quad Core microprocessor SKU.

In chipsets, we had an all-time unit record with sequential growth across desktop, mobile, and server. This reflects the competitiveness of our road map and generated strong bookings for Q3, giving us further confidence in a solid second half demand environment.

We also launched our 3 series chipset family which supports today's Core 2 Duo and Quad processors, but also provides socket compatibility for Penryn, giving the industry a fast migration path to our 45 nanometer microprocessor family.

Our flash results were mixed. The NAND business saw a nice jump in units, densities, and ASPs, but NOR demand was weaker than we expected, resulting in some margin pressure that Andy will describe shortly.

Turning to technology, I am very pleased with the results we are seeing in our development and manufacturing teams. We remain firmly on track to ramp the world's first 45 nanometer logic process in the second half of this year and ship a broad family of 45 nanometer processors by the end of the year.

Our manufacturing organization is delivering faster factory throughput times, higher yields, and improved equipment utilization. As a result of their efficiencies, we are now able to lower Intel's 2007 capital spending forecast by about $600 million without compromising our ability to service a growing computing industry.

There are a number of benefits that we derive from our throughput time reductions. We have reduced Intel's pipeline inventory by several weeks, enabling us to meet customer demand with lower inventory on hand. We are able to iterate new products more quickly, decreasing the time to healthy silicon. Lastly, shorter throughput times allow us to start new wafers closer to the time our customers need the output, giving us truer demand signals and a better ability to respond to a changing mix.

This is just one good example of the results we were looking for when we launched our structure and efficiency review last year. As these projects are combined with our technology and product leadership, we've become a leaner, more competitive and more agile company.

In summary, Intel delivered solid financial results in a competitive environment. We grew revenues above our expectations and we grew profits at a healthy pace compared to the same period last year. As we look out to the remainder of this year and into the next, we see our product and technology advantages continuing to provide differentiation and meaningful opportunities for growth.

Let me now turn the call over to Andy for a detailed look at our financial performance as well as our business outlook for the second half.

Andy Bryant

Thanks, Paul. Despite the competitive environment in a season when results are typically subdued, Intel returned to year-to-year growth during the quarter with higher revenue and higher operating profit. Revenue was up 8% for the second quarter of 2006. The microprocessor business delivered double-digit revenue growth, led by notebooks and servers.

Microprocessor and chipset revenue for notebook computers were each up over 22%. While pricing trends and manufacturing start-up costs weighed on gross margin, operating income grew by 26%. Inventories were lower than at the end of the second quarter of 2006 and the first quarter of this year.

Tax items during the quarter added $0.03 to earnings per share. We are forecasting sequential and year-to-year growth in the third quarter and foresee an improving second half with strong product and the launch of the 45 nanometer process. We expect margin improvement through the end of the year.

Revenue for the second quarter was $8.7 billion, down 2% from the first quarter and consistent with seasonal patterns. The total number of microprocessor units was up slightly, and the average selling prices were lower.

Unit volumes of chipsets and flash memory products were higher than in the first quarter and unit volumes in motherboards were lower.

Revenue for the digital enterprise group was down 2% from the first quarter, primarily due to lower revenue from desktop microprocessors and the divestures of some communications businesses, partially offset by higher unit volumes at servers and chipsets.

In the mobility group, slightly lower revenue from microprocessors was offset by higher revenue from chipsets, and total revenue was approximately flat for the first quarter. Gross margin percentage of 47% was approximately 3 points lower than the first quarter. Lower average selling prices of microprocessors, chipsets and flash memory and lower sales of previously written-off microprocessor inventory lowered the percentage, net of the incremental contributions from higher unit volumes and lower unit costs for microprocessors.

Although revenue was higher than the midpoint of the range we forecasted in April, gross margin percentage was below the midpoint. While unit demand for microprocessors exceeded our expectations in April, average selling prices for microprocessors, chipsets and flash were below our forecast and the market for NOR flash memory was weaker than anticipated.

R&D and MG&A were approximately $2.6 billion, in line with the forecast and approximately flat with the first quarter. In addition, we had restructuring and asset impairment charges of $82 million, following charges of $75 million in the first quarter.

Again, this quarter the progress we have made in cutting expenses is most apparent in the year-to-year comparison. Spending for R&D and MG&A is down approximately 15% from the second quarter of 2006. As a percent of revenue, spending during this period has declined by 8 percentage points. The number of employees is down by more than 12,000 or 12%, to 90,300.

The provision for taxes in the second quarter was unusually low due to a number of items primarily related to the reversal of previously accrued taxes for transfer pricing and R&D tax credit. The provision in the first quarter was also unusually low as it includes a reversal of previously accrued taxes of approximately $330 million related to a tax settlement.

Fully diluted earnings per share were $0.22. The tax items added $0.03 to earnings per share.

On the balance sheet, total inventories were down more than 5% from the first quarter. Raw materials, work in process and finished goods were all down. Total cash investments comprised of cash, short-term investments and fixed income trading assets ended the quarter at $10.2 billion, $1.6 billion higher than the first quarter. Net cash provided by operating activities was higher during the quarter and net cash provided by investing activities was lower.

Capital spending was $1.3 billion, dividend payments were $650 million, and stock repurchases were $100 million.

As we now turn to the outlook for the third quarter, please keep in mind that unless otherwise specified, the forecasts do not include the effect of any acquisitions, divestures, or similar transactions that may be completed after July 16. I will use the midpoint of forecast ranges when making comparisons to specific periods.

We are planning for revenue to be between $9 billion and $9.6 billion. The midpoint of this range would be an increase from the second quarter of 7% and growth year to year of 6%.

Our outlook for gross margin percentage in the third quarter is 52% plus or minus a couple of points. While lower average selling prices in a competitive environment and higher write-offs in advance of the 45 nanometer process will reduce profits from the second quarter, we expect the impact of lower start-up costs for new manufacturing processes, lower unit costs for microprocessors, and higher unit volumes for microprocessors and chipsets to result in a net gain of 5 points.

Spending for R&D and MG&A in the third quarter is forecasted to be approximately $2.7 billion to $2.8 billion, slightly higher than the second quarter. In addition, in the separate category for restructuring and asset impairment charges, we expect expenses of approximately $150 million. We expect to continue to incur charges as we restructure the company to improve financial performance, but we do not have a full-year forecast for this category.

For the year, we are maintaining our outlook for gross margin of 51% plus or minus a few points. As we have discussed before, manufacturing start-up costs for the year were concentrated in the first half and will decline substantially as we approach the launch of 45 nanometer. The results for the first half when gross margin was 48.5%, combined with the outlook for the third quarter and the year, point to a gross margin for the second half between 52% and 54%.

We have increased the outlook for spending on R&D by $100 million and now forecast $5.7 billion for the full year. The forecast for spending for MG&A remains $5.1 billion. We have cut capital spending target for the year by $600 million and now forecast $4.9 billion plus or minus $200 million. The largest portion of this reduction comes from capital efficiencies from a range of projects, including more efficient use of tools and a better yield. Our forecast for the effective tax rate in each of the remaining quarters of the year is 29%.

Our first half results have set a firm foundation for the year and Intel appears to be on track to deliver increasing returns. Our business remains competitive, but it is essential that we focus on the right priorities. Those priorities, which remained unchanged, are deliver products that customers find compelling; to execute superbly with the ramp of 45 nanometer technology; and to attack costs on all fronts from the factories, in R&D and MG&A.

With that let me turn it over to Kevin for Q&A.

Kevin Sellers

Thanks, Andy. We'd now like to open the line for questions and answers. We'll take as many as time will permit. Go ahead.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from the line of Glen Yeung - Citigroup.

Glen Yeung - Citigroup

When I look at the guidance that you've got for the third quarter revenues, yes, it is in line with normal seasonal, but it only reflects 6% year-over-year growth. I wonder if you could explain why you think the year-over-year growth rate is decelerating from what it was in the second quarter?

Andy Bryant

Well, it is easier to explain how the third quarter relates to the second quarter, relates to the first quarter. If you look at the second quarter actual results, it is at a little bit of the better end of the high end of seasonality, but within what I would call historical ranges. That's where we have pegged Q3 again and probably right in the middle of a seasonal third quarter.

We do believe that the worldwide economy is relatively strong. We didn't see anything unusual by geography. The product families all look relatively healthy. I think we're just positioning ourselves for a seasonally stronger second half.

Glen Yeung - Citigroup

Let me move on to the way you look at gross margins. I know you made the point that it is going to be helped out by lower start-up unit costs, higher volumes. What are your thoughts with respect to pricing in the third quarter? and I wonder if you could be specific on both microprocessor, but also what you're seeing on flash given that it seemed to hurt you in the second quarter?

Andy Bryant

Well, I will do the best I can. Why don't I start with a high level explanation of gross margin Q2 to Q3, and then we can talk a little bit about the pricing environment.

If you look at the improvement of 5 points, it comes from a variety of places. We do expect unit volumes to be up. We also expect average selling prices to be down a little bit, and we expect unit costs to be down. If you take all three of those categories and say those are kind of microprocessor operating items, you get almost 3 points of good news of gross margin quarter to quarter.

The fact that you don't have the start-up costs, obviously you don't have as much in start-up costs in the third quarter versus second quarter, there is almost 2 points of good news in margin.

You also have an extra point of what I will call miscellaneous items. For example, because we're selling the NOR flash business depreciation got suspended, so there is no depreciation in the third quarter. It makes margins a little better. An extra point of a lot of little things like that. The negative offset is as you begin to build the 45-nanometer product that's not yet qualified for sale, you can't put those costs in inventory, so we will have a bit of a drag on the build of product that isn't qualified for revenue until the fourth quarter. That's 1 to 2 points negative.

Now, as far as the pricing environment. It was a more competitive pricing environment than we thought in Q2, and we expect it to continue to be somewhat competitive which is what you're seeing in our margin outlook for the year. We believe the best defense against the competitive price environment is better product.

If you look at what's happening with us the last year, you've seen better products quarter by quarter by quarter. You've seen improved product differentiation, 45 nanometer coming out; the Penryn product family, as Paul talked about. So what you're seeing is Intel's commitment and focus to making our products better and better and better which is the best defense we have in a competitive pricing situation.

Glen Yeung - Citigroup

Andy, is the pricing pressure the same now as it has been all year? Is it getting worse or getting better?

Paul Otellini

I would say it is different, Glen. It is much more targeted now at the low end of the desktop and even a little bit of the notebook marketplace, and a year ago it was higher in the stacks in many areas.

Glen Yeung - Citigroup

That's helpful. Thanks, Paul.

Operator

Our next question comes from the line of John Lau - Jefferies.

John Lau - Jefferies

Paul, I was wondering if you can give us your comments with regards to your outlook on demand? Where do you see the growth opportunities going forward that would surprise you? Are you anticipating an even stronger launch for Santa Rosa in Q3? Where can we see this upside and strength? Is it in the emerging markets? Just a little bit of color on that. Thank you.

Paul Otellini

Sure. When you say growth opportunities, I am assuming you mean the second half of this year, not long term.

John Lau - Jefferies

That's correct.

Paul Otellini

You're right. As Andy said, we saw strength in the second quarter across the board. It was essentially in all geographies, in all segments of the market in computing space. As we talked about in NOR flash there was some softness from a demand standpoint and pricing pressure.

But if I stick to computing, I think what we're likely to see in the second half of this year is an expansion of that. I see particular interest in notebooks. You're right about Santa Rosa. It is off to a great start, and I would expect the volume to continue the transition very rapidly from Napa to Santa Rosa.

We're seeing very good progress on our Quad-Core Xeon DP server products that I talked about. We're now sampling Caneland which is our first core-based micro architecture platform for MP, for multi-processing servers, and that goes into full production later this quarter. We would expect to see expansion from both mobile, globally, and servers globally and inside the segments, MP presence in servers.

John Lau - Jefferies

Now with regards to the pricing pressure that you mentioned, I assume that most of that was in the desktop area. Do you see as you continue to emphasize more of that mobility and the Quad-Core version of the server market you will be able to mitigate some of that downside?

Paul Otellini

One would hope so, although the low end of the consumer notebook market is very competitive as you've seen, obviously, if you walk through the retail shelves nowadays.

Operator

Our next question comes from Michael Masdea - Credit Suisse.

Michael Masdea - Credit Suisse

First question is high level. If you look at where you were at the beginning of the year and you look at where you are now, it seems like you've increased your lead both on the manufacturing side and product side, yet pricing still seems fairly aggressive, even to the point where it seems to have surprised you a little bit. Help us reconcile as to any guess as to why that is?

Andy Bryant

We expected a competitive pricing environment most of the year. I agree it was a little more aggressive than we thought in the second quarter, but not much compared to our expectations. We know that AMD will continue to sell parts, we know they'll continue to sell aggressively. Our intent is to continue to protect and build share if we can. Our intent is to bring better products to the marketplace and as Paul said, focus on the high end where we think we'll have less competitive pressure.

Michael Masdea - Credit Suisse

On another area, the stock buyback, your peak was over 3 billion, and we've been pretty steadily trending down now to about 100 million. Is there any point in which you start to step that up? Is it just a function of the stock price or is there something else going on there?

Andy Bryant

We do stock buyback probably a little different than most. We do meet on with our board quarterly, we talk about strategic projects, we talk about cash reserves. We set a cash target, we protect the dividend, we pay the dividend and then buy backs are almost a drop off from that equation; not exactly, but close.

If our business continues to generate cash either we have to come up with some really good ideas fast or you would see us start to buy back some more.

Operator

Our next question comes from the line of Chris Delaney - JP Morgan.

Chris Delaney - JP Morgan

Can you just talk about the inventory trends? Your inventory came down by about eight days. Did that have anything to do with the lower margin? How should we be looking at utilization rates in the second half of the year?

Andy Bryant

No, I don't think it had anything to do with margin. I understand your point. Clearly a little bit, but in reality let's think about inventory. Inventory down over $200 million, part of that was we shipped more product. We said unit demand was higher; but part of that was the improved throughput. So if you can think back to the analyst meeting when Bob showed that we were getting throughput improvements, that allows us to stage less inventory and raw material in the factories, so I can save inventory there, and we aggressively focused on that in the second quarter.

The second thing is the capital came down because of improved efficiency. Improved efficiency means either higher yield or higher time on equipment. If you can have more good product come out of what you put into that factory again, you don't have to have as much inventory in WIP to satisfy the same demand.

All of those things were in play to try to make sure we saved inventory if we could. No question, if I were to start more wafers I would have absorbed more spending, I would have made my Q2 number look better but at the same time then I would have had a higher cost one day when I had to get rid of the excess inventory. So we think we're doing the right thing, and yes you're right; there is some small connection between the two.

As far as the trends, I would expect inventory in the third quarter, I think flat is a good target in a quarter with increasing revenue. I would like to see that. Another piece I would point out to you is if you look at all of our inventory, our inventory in the channel came down which is unusual in a second quarter. So again, a lot of good things happened to keep inventory down in the second quarter.

The next question was under-utilization charges. We did have some in the second quarter. When we started the quarter we told you we expected none. We had some in the flash network as demand was weaker there. We also had some in the 8-inch logic network; nothing in the 12-inch network for processors or chipsets. Looking to Q3 I would say we probably have a little bit in the older networks, nothing in the newer networks.

Chris Delaney - JP Morgan

In the yearly gross margin guidance, are you guys assuming some continued problems on margins from the NOR Flash business?

Andy Bryant

Am I anticipating it? First, no. If anything I think it gets boy, I hate to say a little better, but let's say a little better. Because of the weakness in the second quarter we had some reserves, we have a high unit cost because we had less full factories, we had the under load charges, I think we've gotten the business resized right where we want it so we shouldn't see extraordinary bad news. I would say business as usual through the back half of the year.

Operator

Our next question comes from Hans Mosesmann – Moors & Cabot.

Hans Mosesmann – Moors & Cabot

Thank you. Paul, why did desktops do a lot better than expected? Is this a result of Vista? Is it market share gains? Is it demand you were going to see in Q3 that got pulled into Q2? Can you explain?

Paul Otellini

The principal upside we saw in desktops this quarter was in the channel, and as Andy pointed out and I think I mentioned in my comments too, our channel sales were actually up sequentially this quarter in a seasonally down quarter. The bulk of our products sold through the channel is desktop product which principally is non-U.S., non-Western Europe markets. So if I were to say one large chunk of upside was in the emerging market desktops.

Secondly, we increased our business in some of the low end segments of the desktop business at the OEMs. Going forward since that is so competitive, we're going to be very selective about what business we take there from a margin perspective.

Hans Mosesmann – Moors & Cabot

As follow-on, if you can give us a sense of ASPs in notebooks and servers in the quarter: were they up, flat, down?

Paul Otellini

I don't think I want to go farther than what I said, which was that we saw strength, that our technology position in those two segments allowed us to somewhat offset the pricing pressures in the low end of the PC market.

Operator

Our next question comes from Sumit Dhanda - Banc of America.

Sumit Dhanda - Banc of America

Good afternoon, guys. Andy, a question for you. The 45 nanometer product cost that you expect will have an impact on gross margin, help us understand if that's not normally incorporated as part of your start-up cost projections earlier on in the year?

Andy Bryant

No. The start-up costs are the costs incurred before you begin production. When you have what I call prequalified production costs, the odd part of our accounting is until I can be relatively sure I can sell the product or the product is going to be good, we don't value it, so it ends up going as a period cost.

However, if the product we build is good, we will sell it in the fourth quarter so we'll be selling from previously reserved material is my guess. Again, that's just making sure you don't value product you can't sell, and we just haven't crossed those hurdles yet.

This is pretty typical with the new process. You go back over the years, you'll see every second year or so we end up with one quarter where we have a bit of a dip in gross margin followed by the valuation quarter where you get a pretty good uplift.

Sumit Dhanda - Banc of America

I can't remember if you quantified this earlier in the call, but did you quantify how much this particular factor is impacting gross margin?

Andy Bryant

What I said was it is 1 to 2 points.

Sumit Dhanda - Banc of America

The other question I had for you, Paul, you commented on the pricing and you said it is a little different, it is relegated to the low end value desktops and some parts of notebook. But as you look forward, are you expecting an environment where there is some pressure in Q3 commensurate with what you saw in Q2 because at the end of Q1 when you reported first quarter you sounded more optimistic about the pricing environment.

Paul Otellini

I think we've got two trends here, as Andy pointed out. One is the continuing competitive nature of the low end of the PC marketplace. Offsetting that in places where our technology lead is really gaining some significant traction, differentiation in the marketplace.

So obviously we're trying to move as fast as possible towards a product mix that reflects the latter. At the same time there is still a big chunk of the market out there that lives in that very competitive space. We have built the integral of that into our forecast in terms of what we expect for the second half.

Operator

Our next question is from Joseph Osha - Merrill Lynch.

Joseph Osha - Merrill Lynch

First, on your NOR flash business I am wondering, is there an attempt here to maybe focus a little bit more on profitability? Did you walk away from some business this quarter?

Andy Bryant

No. We would have taken almost any business that moved in this quarter. We're still very aggressively pushing parts and trying to sell. It is just that our end markets were softer than we expected.

Joseph Osha - Merrill Lynch

Secondly, looking in particular at Penryn, smaller die, more output, when you think about latter part of this year, first part of next year, do you worry at all about the ability to absorb that output and keep utilization up without stacking up inventory?

Andy Bryant

I don't believe that's a problem certainly in the latter part of this year and the first part of next year. As we always do, we adjust factories, take old factories off line which allows you to put part of the parts that was being built there into the new factories as you go forward.

So if you look at the factory loadings today, we are pretty comfortable that the factories stay full. There will always be some disruptions. You may have a quarter where you have a month or so that you have some under loading, but in general the factories are planned pretty well to what we see as demand.

Joseph Osha - Merrill Lynch

Can you maybe give us a slightly longer-term look at how you're targeting operating expenses? I am interested in maybe whether there is some kind of 2008 target in monetary or percentage of revenue terms?

Andy Bryant

What we have said is we would like to have minimal, if any, growth in OpEx for next year, so we're trying to keep a tight lid on it. Will it grow some? It could. We haven't done our plan yet. We haven't looked at the project list yet, but the intent is let's continue to find one more year's worth of efficiency savings to fund our growth, if at all possible.

Joseph Osha - Merrill Lynch

That's the whole year '08 against the whole year '07 number, that's how I should think about it?

Andy Bryant

Yes, sir.

Joseph Osha - Merrill Lynch

Thank you very much.

Operator

Our next question comes from Uche Orji - UBS.

Uche Orji - UBS

I wanted to get some clarity as to how you intend to address the low end which remains competitive, and reconcile that with margins. The question here is, are you able to manage both or are you going to be willing to cede market share in the low end in the interest of preserving margin?

Paul Otellini

Well, that's a real time equation Uche. You've seen us walk the line there and I think you will see us continue to walk the line in terms of what we're going after secularly. We have no intention of walking away from any segment of the computing market. That's why we spent quite a bit of time explaining our thrust towards lower cost products designed for the low end, low powered, low cost segments of the marketplace in the last analyst meeting.

As those products come online in 2008, that gives us a significantly lower cost structure than we have today to go after these markets in an increasingly profitable fashion. So it would be crazy to walk away from them and then to try to jump back in. You will see us continue to engage where we think it makes prudent sense and leave some stuff on the table where it doesn't.

Uche Orji - UBS

On the manufacturing side you've had so much efficiencies and we've seen your CapEx come down and congratulations for that. But let me just understand if I look at 45 nanometers as that starts to ramp, should we expect these efficiencies to continue and what kind of picture does that create in terms of how we should think about CapEx and sales on an ongoing basis for Intel?

Andy Bryant

Well, we'll certainly continue to focus and drive on efficiencies. But if you ask me do I think I have another rabbit in my hat to find another $600 million savings this year? No, I don't think so. I would think of the savings we've got in this efficiency program as pretty much what we'll get for a specific generation, but every new generation leaves me, if I can maintain the improvements I've gotten, it gives me essentially $1 billion per generation forever.

So I am trying to make sure we protect the savings we've gotten. Will we find some ways to extend it? Sure, we'll find some more ways, we'll find some more efficiencies, but I don't think it is going to be a big effect on capital this year.

Operator

Our next question comes from JoAnne Feeney - FTN Midwest.

JoAnne Feeney - FTN Midwest

A quick question for you about the ASP decline. I know you have answered a number of these, but could you enlighten us on the role of the increasing ramp of the chipset? Is that figuring into that ASP decline? Is it partly a mix shift there?

Andy Bryant

Not in the ASP decline we're talking about. Clearly, if you look at the gross margin percentage, chipsets don't have quite as high a margin as microprocessors and as they grow faster, there will be a bit of a mix effect, but what we've been talking about we've been pretty much focused on the microprocessors being down. So yes, there is a bit of an effect for chipsets. It is not material in terms of the explanation.

JoAnne Feeney - FTN Midwest

Not in terms of the gross margin decline then, just a bit?

Andy Bryant

No.

JoAnne Feeney - FTN Midwest

So the mix shift primarily was towards the lower end of the desktop and that's what primarily dragged down the ASPs? Is that right?

Andy Bryant

Well, it is certainly what Paul said before, price competition at the low end of the PC including low end retail type laptops.

JoAnne Feeney - FTN Midwest

Then on the CapEx side, your improved efficiencies are enabling you to drop that down by $600 million. Is it also the case then that you're able to run the fabs at higher capacity utilization? Is that an implication that we should draw from this lowered CapEx level?

Andy Bryant

A little bit, yes. Again, it is not a big number, but when you're talking about a factory that costs $3.5 billion to $4 billion, small improvements mean more dollars.

Operator

Our next question comes from Tim Luke - Lehman Brothers.

Tim Luke - Lehman Brothers

Thank you so much. Just on the NOR side, just to go back to that, when you're saying that you feel that margin wise it may be business as usual, should we then think that the operating loss level will be broadly similar in the second half to the way they were -- that $280 million to $290 million level -- that it was in the first couple of quarters or should we be thinking about a change there?

Andy Bryant

Paul, we're not making a segment forecast for cash for Q3 and Q4. What you should be thinking of is we'll continue to fight for revenue. This is on the NOR side, what you're seeing is NOR and NAND combined.

NAND, you will see us continue to fight for revenue. You will see us continue to try to protect and grow that business. We are trying to form a new company with it. We don't want to decimate it. The accounting will make it a bit odd.

Remember in the NOR business once we've agreed to form the new companies and sell assets to the new companies, accounting then stops depreciating those assets, so you are actually going to see some good news because you will have less costs because of less depreciation. The spending will be pretty constant, and again, the revenue will determine how good we are at finding customers.

Tim Luke - Lehman Brothers

Also, just on the inventory side, in describing your expectation of being fairly flattish through the coming quarter, given the sort of seasonal fourth quarter ramp, isn't that fairly unusual for you to keep the third quarter inventory flattish? How should we think about framing expectations there or your comfort level in terms of the inventory levels?

Andy Bryant

With a forecast of inventory flat, if I can maintain flat that says we have continued to improve inventory efficiency and usage, so there is work I still have to do, we still have to do, in order to maintain that. I would expect it to grow in the fourth quarter, but I would like to see us continue to focus on the gains we've gotten in throughput, continue to take those to the bottom line in terms of inventory control which will mean more revenue with no more inventory.

Tim Luke - Lehman Brothers

Lastly, just for Paul, on the service side, I was wondering if you would give some color given that you have quite a broad product ramp and the competitor also has a new product coming out at some point in the second half and just your expectations for maybe the market demand, but also how you figure ASPs may begin to trend there in that arena? Thank you.

Paul Otellini

Well, I think the overall trend in server ASPs is likely to be one where they erode a bit, principally driven by the market shifting from MP-based servers to DP-based servers over time; or more precisely, DP out growing the MP section of the market so it becomes a higher percentage. The DP server chips from us and others sell for substantially less than the MP server chips just like the systems do.

Part of this is you have got a mix shift inside of servers towards DP that had been accelerated by the introduction and ramp of the Quad Core DP, which essentially a cheap eight-way system, and I really think that trend, along with virtualization in the data center are really the large secular trends to watch over the second half and even into 2008.

Tim Luke - Lehman Brothers

With any type of marginal revenue expectation that we should be aware of?

Paul Otellini

I suggested earlier that I think that one of the reasons we're optimistic about the second half in the numbers we've given is the expansion that we expect in mobile and in servers.

Operator

Our next question comes from the line of Cody Acree - Stifel Nicolaus.

Cody Acree - Stifel Nicolaus

Thanks, guys. With your yields as strong as they were this quarter, with throughput up, pretty decent unit volumes and maybe a surprise in the decreases in inventories, internal and external, are you incrementally a little more comfortable in that second half gross margin expansion? Or is any of that breathing room just simply being offset by pricing?

Andy Bryant

I always say I have more comfort in my second half, only because I was comfortable with how Q2 came out. No one has even asked about the Q2 margin, but if you look under the covers, what you find is the gross margin percentage for the microprocessor business was as expected, and flash took the company down a point. So given I have that data point behind me, given the information you just described, I am more comfortable with my cost forecast. We have a seasonal second half. I am pretty comfortable with that. I am more comfortable with that second half margin, yes.

Cody Acree - Stifel Nicolaus

With AMD's Barcelona, with your upcoming Penryn, I think others have mentioned you really should both have somewhat of a more respectable product offering. Do you believe that there is more of an equilibrium that some of your OEMs are going to push you and AMD toward, that you start to get some real diminishing returns on this pricing battle back and forth that you guys both have had?

Paul Otellini

I think that the overwhelming issue for our customers is how they compete with each other in the marketplace, and to me that means particularly in the segments where the high performance matters. In the professional notebooks and the server space, not having the best product is a huge penalty in terms of their ability to gain market share or sell product.

So I look at the relative product lines of us versus others in the second half of this year and see us in those segments much stronger. Therefore, I think that it is in our customer's best interests to be able to use our products simply because it helps them sell against each other. The alternative is that they will be selling a product with less performance potentially at less price, but that equation doesn't fly as well in the performance-oriented segments of the marketplace.

In these two particular segments, DP servers and professional notebooks, it is not just performance that matters, it is the power efficiency. You will see us extend our lead in power efficiency from where it is today over the second half of this year as we bring out the 45 nanometer based products.

I feel pretty comfortable that if they intend to do well in the marketplace they are best served in these performance-based segments using Intel.

Operator

Our next question comes from Brian Piccioni - BMO Capital Markets.

Brian Piccioni - BMO Capital Markets

With respect to the NOR flash business, are you in a position to provide us with any sort of enhanced detail with respect to how that will affect your operating model into 2008?

Andy Bryant

No more than what Stacy has already communicated, but I can reiterate. We would expect revenue to be down when that business is sold off. We would expect gross margin percentage to be up, it could be 1 to 2 points. We would expect spending to be down a little bit, and our share of the gains or losses of that newly formed company likely come back to us in the gains and losses from investments, so it basically says probably the bottom line doesn't change much in the short term, the operating lines of the P&L are a bit improved.

Brian Piccioni - BMO Capital Markets

You sound very confident in this particular call about introduction of your 45 nanometer parts later on in the year. I was wondering if you would be able to provide us with any milestones to look forward to with respect to the progress you would be making in that segment?

Paul Otellini

We are sampling all versions of the product to-date: notebook, desktop, and server. So that's a milestone that I think we've talked about before but one which is important because if you're confident enough to sample the customer base, particularly at the high-end of the server products, that's a good sign.

The next milestone you will hear from us is probably something we'll talk about at IDF in September which I will allude to later on in my closing remarks. You will see a bit more of the product line there. The final milestone is when we start shipping the darn things.

Operator

Our next question comes from David Wu - Global Crown Capital.

David Wu - Global Crown Capital

Paul, when I look at the stuff that's going on in retail notebooks, your Pentium Duo, it seems to me has as good a price point as any out of the competition, and yet the competition appears to have higher unit growth in that segment. In your mind, why would the OEMs push their versions versus your version?

For Andy, can you help us a little bit on the NOR business? Because I look at your break out by segment and the losses aren't materially higher in Q2 versus Q1 for the flash business. I just wondered where that 1 percentage point gross margin hit took place. Can you also give us at least a rough guess at what's the mix between the NOR and the NAND in the current reported numbers?

Andy Bryant

Which one do you want first?

David Wu - Global Crown Capital

The simple one.

Andy Bryant

Which?

Paul Otellini

Both of them. Let me answer the retail question. There are a couple of things going on here, David. First of all, you're right. Pentium Duo is in our view a superior product to the competitors at those price points. It's got lower power, longer battery life, higher performance, et cetera. So we believe that it ought to outsell for that low end of the retail range, and in fact it is doing quite well in a worldwide retail basis.

For reasons that you need to ask our customers about, we tend to do much better in their line-ups offshore than we do on-shore. If you were to go to Europe or go to Japan or go to China, you would see a much stronger Intel mix in those low end segments of the notebooks than you do at Best Buy or the stores here in the United States.

For the life of me I can't figure out why that happens, although we tend to try to explain to customers that the product is better.

Andy Bryant

The NOR versus NAND business, first of all, we don't break out the reporting segment at a sub segment level, so I am not going to split the two for you. In a reconciliation of margins from Q1 to Q2, flash is not a reconciling item. Versus our expectation of where we thought Q2 was coming out flash is a reconciling item. So our expectation going into the quarter was NOR would kind of hold its own and NAND would improve. NAND did improve. It had reasonable revenue growth and a better environment, so we were pleased with that. NOR deteriorated.

What happened was the NOR demand dropped. We had under loaded factory charges; we had a higher cost per unit of products sold because we had under loading factories. We had demand reserves because products built for specific customers no longer were being taken by those customers.

So all those things together add up to about a point of margin versus our expectation. Quarter to quarter, the entire change was essentially microprocessor related.

Operator

Our next question comes from Ross Seymore - Deutsche Bank.

Ross Seymore - Deutsche Bank

You mentioned about the performance being the determining factor in winning designs with your customers. It appeared that took place in the first quarter and second quarter, at least on a unit basis, with you gaining share. Given that your competitor doesn't seem to be announcing too many new products at least for the third quarter, I just wonder why you guys would be guiding in line with normal seasonality if market share gains seem to be something you pulled off in the last couple of quarters?

Paul Otellini

Well, I didn't make any comments on market share in the second quarter and I have learned that the best thing to do is to avoid that if possible and let the market research people opine after the fact. That's the easier way to deal with the ins and outs of inventory draws and large replenishments.

What you'll see us do, particularly in notebooks in the second half of the year, is move all of our advertising back from establishing Core 2 Duo on as a brand on a worldwide basis where it has been for the last year; the last 12 months, 100% of our own Intel advertising has been based upon that and you'll see it swing to Centrino almost entirely.

Our view is that we're going to hit that real hard in the second half starting in the August timeframe on the web and in print and in television, focusing on the benefits of the product line as expressed to end users in terms of the battery life and so forth. We are optimistic it will have a positive impact.

Ross Seymore - Deutsche Bank

Maybe a follow-up on the channel side of things. You mentioned that that was a positive in the quarter for you and actually grew, which is better than seasonal. Do you think that's you taking share in the channel or just the channel being stronger than the OEM side?

Paul Otellini

I think the channel had a good quarter first of all. , and our channel customers tell me that they are making very good margins on Intel products which is a combination of the strength of the product line and the stability around the pricing and the predictability around the pricing.

If you look at things like the gray market on our products, it is actually very close to our pricing now which allows our distributors and the dealers to make good margins. I think that's been the single biggest impact this quarter and that, plus the fact that the emerging markets were relatively strong where they tend to play well.

Ross Seymore - Deutsche Bank

Then a final quick one, you mentioned last quarter that there was a little bit of excess inventory floating around in the microprocessor space. I think you said it wasn't Intel inventory. Do you get the sense that that's been cleaned up heading into the third quarter or just an update on the status of that would be helpful.

Paul Otellini

Well, ours has certainly been cleaned up and is in very good shape as we talked about. I think there remains to be seen what others will say. The rumor out there is that the inventory in other parts of the channel is a bit long right now.

Operator

Our final question comes from Krishna Shankar - JMP Securities.

Krishna Shankar - JMP Securities

Paul, you talked about the difference in pricing and performance between the low and the high end. Can you give us some sense for the growth rate of the low end notebook and server segment versus the high end? I just want to get a sense for relative growth rates, especially with performance being very competitive now in low end consumer notebooks?

Paul Otellini

Well, I actually don't think the latter part of your sentence is correct. I don't think there is an equivalent level of performance or at least energy efficient performance in the low end of the marketplace. I think we still tend to do well there.

But you're asking me for a mix question which is a level of granularity I can't give you and it gets really to the ASP question that we've discussed at length today; so I am afraid I can't help you there. Clearly it is in our best interest to drive those two segments as aggressively as possible and that's what we're doing.

Kevin Sellers

Thanks, Krishna. Thanks, Melanie. We're going to just close our call now and as we do so I am going to turn the time over to Paul for a few brief closing comments. Thanks.

Go ahead, Paul.

Paul Otellini

Thanks, Kevin. Thank you all for your questions today. As I said at our analyst meeting in May, we plan to extend our technology leadership in the second half by ramping the industry's first 45 nanometer manufacturing line along with Penryn, a complete family of 45 nanometer processors.

Beyond that, we are far along in developing the Nehalem micro architecture for 2008. Within our 45 nanometer generation, you'll see us extend the reach of Intel architecture into mobile Internet devices, consumer electronics, and parallel processing with new designs based upon the new Silverthorn and Larabee cores. We're very excited about the future of our technology, and I hope to see many of you at the Intel developer's forum in September where you will learn more about our initiatives.

Good afternoon and thank you all for joining us.

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