Intel: This May Take A While ...

| About: Intel Corporation (INTC)

First things first, I'm long Intel (NASDAQ:INTC) at an average cost of $21.27. I wanted to get that out of the way so that the perspective from which I am writing is clear. The reason I own Intel is for the growing dividend; so you could say I have a fairly long-term focus with this holding. If that was the end of the story however, this would be a fairly unremarkable article. After all, Intel is currently yielding around 4.30% and has raised its dividend for the last 9 years, has little debt, has enjoyed more than 2 decades of high margins and unmatched pricing power within its industry. To quote Bob Dylan however, The Times They Are a-Changin'.

The Danger of Over-Serving Your Customers

It is not a stretch to say that Intel has dominated the personal computer processor space for years. They have done this by focusing R&D on relentlessly identifying ways to squeeze extra performance out of their products and by continually improving their manufacturing processes at a break-neck pace. This is how industry leaders stay on top - innovation and supplying more of what their customers want. The problem with this approach however, is that over time, a gap begins to grow between the level of performance that you are supplying your customers and the level of performance that your customers need. In the end the volume will flow towards the latter of these two categories.

How is this relevant for Intel? If you have paid any attention lately, their biggest challenge comes from the mobile space and the slow response to it. Many times a market leader can be caught over-serving customers when a substitute product arrives that is easy to dismiss for some reason. In Intel's case, it appears in hindsight that the threat ARM Holdings (NASDAQ:ARMH) represented was not entirely understood. 5 years ago an ARM processor was low powered (in addition to low power), cheap, and there was not a great deal of software optimized to run on it. As everybody knows however, consumer technology has taken a hard left turn and between smartphones and tablets, an ARM processor fits the need for good enough computing. In the meantime, Intel has continued adding features and power to their consumer line of products. In other words, it's not like their products have gotten worse over night, it's just that consumer preference shifted beneath them and it hasn't mattered that they have continued to pile on performance.

So Where Do We Go From Here?

As of the 2011 annual report, 66% of Intel's revenue was drawn from the PC Client Group (PCCG) operating segment. That is essentially what is at stake here. Maybe not all it but certainly a large portion of it will continue to face pressure from substitution within the market. If you are at all bullish on Intel, you need to believe that they will come up with a competitive mobile chip to combat the competition. That debate (whether or not Intel succeed in mobile) has raged within the Seeking Alpha confines over the past few months and will not be resolved in this article. Essentially, if you are bearish on Intel's mobile chances, do not invest with them. Since I fall in the bullish camp however, I'm more interested in the case of what happens when they have a competitive mobile product.

Starting with that assumption, there are several clear implications. First and foremost, it will take time for Intel to gain market share. According to one source, the mobile processor market will reach 1.9 billion units by 2016. This estimate includes mobile PCs in addition to handheld game consoles, portable media players, smartphones, and tablets. While Intel currently dominates the mobile processor segment, it seems likely that the resulting share of the market will shrink. In order to grab share from the remaining slices of the pie, Intel will need to not only provide a superior product but will also likely take a margin hit from the high levels of competition. This means both revenue and profit are at risk in the near term - which Intel has confirmed in their latest guidance.

My core thesis however is that once Intel creates a competitive product (which may already exist), their tick-tock product development strategy will allow them to put increasing amount of pressure on the mobile market share currently held by ARM based processors. This is especially true when you consider one of Intel's core competencies - their manufacturing capabilities. One of the key product advantages that comes along with these manufacturing improvements (currently moving to a 14 nm processes) is a reduction in processor power consumption. If Intel is able to marry their mobile processors with an industry leading manufacturing process, it is conceivable that they will be able to provide their customers with a true "delighter" - improved battery life. For me, this is the key dimension where mobile processors need to improve and it is the dimension which Intel is best positioned to provide a superior product.


In order for Intel to reposition itself so that it is no longer over-serving its customers, it needs to compete successfully in the mobile space. Doing this will come at the expense of reduced revenue growth and decreased margins over the short to medium term (something like a 3 year time frame). Once this transition is complete, Intel's technological and manufacturing leadership will allow them to once again perform at a high level.


All of this is not to say that I believe ARM is in for a difficult time in a few years. In fact, they are positioned particularly well with regards to their business model (no manufacturing, just design), distribution channels and potential future trends like "the internet of things." I simply can't recommend investing in them due to the extraordinarily high P/E valuation that they currently have.

Disclosure: I am long INTC. 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.

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