Intel: Don't Be Left Holding The Bag

| About: Intel Corporation (INTC)
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The biggest mistake investors can make is to let their emotions come into play when an iconic American company like Intel Corporation (NASDAQ:INTC) loses its competitive edge.

It's the most common way institutions take individual investors' money. Institutions know that 9 out of 10 average investors will chase and buy stocks at their highs - as analysts upgrade them. Correspondingly, individual investors are expected to keep holding the stock as its price falls, and the institutions bail. Private investors are always the bag holders.

Intel Corporation has been in many individual investors' portfolios for decades, and it's an easy stock to get emotional about. Stockholders enjoyed a healthy 28% in 2013, despite the obvious tectonic shift in the computing world from PC to mobile and Intel's inability to move successfully into that new market.

Long-term investors in Intel are currently getting support from some analysts for holding on to the stock. Even as recently as last month, Citi upgraded its rating for Intel to "Buy," citing better-than-expected guidance on PC shipments.

Is Intel's story still intact? Until recently, I was a long-term Intel optimist, but that changed a few days ago. If you listened to top management's remarks on Intel's quarterly earnings - in particular several crucial comments made by Intel Chief Executive Officer Brian Krzanich - you may agree with me that imprudent individual investors are going to be left holding Intel's bag in the near-term future.

And that's not because the earnings were dismal. Truthfully, faltering earnings are the norm for Intel these days.

Intel reported fourth-quarter revenue that was slightly higher than what Wall Street expected - a 3 percent increase to $13.9 billion over last year's fourth-quarter figure. Basically, profits were just about flat at $2.6 billion, versus $2.5 billion a year ago; missing analyst estimates by a penny a share.

Others have discussed Intel's fourth quarter earnings in sufficient detail. The key point is the forward guidance, which for 2014 calls for sales to be flat. This means that 2014 will be Intel's third year in a row with lower or no revenue growth.

Even that might have been palatable. After all, PCs drive Intel's earnings, they always have, and the PC market is in the toilet.

The trigger for individual investors to reconsider their investment in Intel came later. During the earnings call, CEO Brian Krzanich dropped a bombshell when he announced Intel's goal to sell 40 million Intel-based tablets in 2014.

Let's pause a moment for a bit of history.

Intel exited 2013 with 10 million tablet sales. So Krzanich is saying that Intel plans to quadruple that volume this year.

This kind of explosive tablet growth is almost a must-do for Intel, by the way. Intel's PC sales have been slumping, and Krzanich made it clear last year (in mid-July, during the earnings call) that "building ultra mobile chips was now the company's highest priority."

On the face of it, the goal sounds great. We all love aggressive goals. But if you're an Intel shareholder, you have to ask yourself how on earth Krzanich plans to do this. Especially since Intel's foray into the mobile market (thus far) has been a kludge in progress.

Intel's Bay Trail was designed for the high end of the tablet market - Windows 8. In the meantime, most of the growth was happening at the lower end of the tablet market, so Intel flipped direction and Bay Trail was promoted (or demoted, depending on your point of view) to the low-cost tablet market. Unfortunately, Bay Trail is not nearly as appropriate for that segment, as it does not have the level of integration needed at the lower end of the market.

Chip suppliers that get the best product out, and do so the fastest, at the best price points, win the design sockets. Bay Trail competes directly with tablet SoCs from Qualcomm (NASDAQ:QCOM), Nvidia (NASDAQ:NVDA), and others. With current Bay Trail T-chips at $32, way above competitors' pricing, many individuals believe Intel is simply too late to the mobile market.

Krzanich, by the way, is one of those individuals. In an analysts meeting in November, 2013, he explained exactly how Intel intends to get the edge it needs to survive in the tablet market.

Intel is going to buy it.

Contra Revenue - When You Can't Compete, Buy Yourself A Place at the Table

Seeking Alpha columnist Russ Fischer has been cited by CNET as the source who broke the news on Intel's "contra revenue" in November. Last week, IDG news did as well. Through a program first disclosed at its financial analyst meeting in November, Intel will be paying tablet makers to cover the additional component costs of using its Bay Trail chips instead of ARM-based processors.

Bay Trail doesn't have equivalent functionality integrated onto the chip as other tablet SoCs, so Intel plans to pay tablet makers to cover the additional costs for functions like communications, or to print additional layers onto Bay Trail circuit boards

How significant will this payout to tablet makers be? Fischer estimates the total loss to Intel will be $1.2 billion.

Krzanich shed a bit more light on this plan during Intel's quarterly earnings call. At one point, he was asked what proportion of Intel-based tablets would be supported by its "contra-revenue" subsidies. After a little hesitation he said, "The majority of projects we have in 2014 use some level of contra revenue."

Here's the takeaway. Remember when seeing the sticker "Intel Inside" made consumers willing to pay a premium for a PC? By contrast, here's where Intel is today. They have fallen so far behind in the tablet market, next year they will pay you (by subsidizing the tablet manufacturer) for buying a tablet with "Intel Inside."

Sorry, Intel. That idea? It's terrible.

Love on me, Intel is saying. And I'll pay you. We've all heard that one before, in one form or another. And we all know what comes next.

PC World said recently that Intel's management decided to pursue "contra revenue," because subsidies will seed the market with "Intel Inside" tablets. By 1915, when Intel's Broxton and SoFIA chips appear, Intel hopes to end the program.

The key words in that paragraph? "Intel hopes."

It gets worse. Even with SoFIA, Intel has already made a significant concession. The chip will be manufactured not by Intel's own fabs, but by contract manufacturer TSMC (NYSE:TSM). This decision reflects Intel's need to get the product out quickly, said Nathan Brookwood, principal analyst with Insight64.

SoFIA going to TSMC is another bombshell. By not using their own multibillion-dollar fab houses, Intel is not only losing money, those fab houses will quickly obsolesce. What's worse, some of these facilities are currently not being used. As recently as 2011, Intel invested $5 billion in a fab in Chandler, Arizona for instance. That facility? It sits empty.

The point isn't that Intel should be using the Chandler fab house for SoFIA - that's not possible, but that Intel is building fab houses for the wrong technology. Intel's strength has traditionally come from its manufacturing prowess, and those factories need to stay busy. Otherwise, the company risks becoming another "me-to" design house--with their only edge their bulk and size.

Here's how Intel's Chief Finance Officer Stacy Smith explained the impact of contra revenue on Intel's financial picture.

"The impact of taking Bay Trail into the broad tablet market including the value portion of the tablet market will be a significant increase in the operating loss in this segment and at the corporate gross margin level."

Not to kick a dead horse, but what the heck is going on? Is Intel's top management actually saying we have missed the boat so badly with mobile computing, we are going to have to buy our way in - and hope that we make it?

If so, the odds aren't with them. According to Harvard professor Dr. John Kotter, 70% of all major change efforts in large organizations fail - and the key determining factor is leadership. Krzanich became Intel's CEO in May of last year, on the heels of an IDC report showing a 142.4% year-over-year growth rate for the tablet market. With the report came news that PC shipments had not only stalled, but had declined 11% from previous years. Krzanich is an insider, having joined Intel straight out of college. He's known for his loyalty to the old guard, not for his ability to successfully react to innovation. He doesn't sound to me like a good bet.

Intel's History of Success

At the end of the day, corporations exist to make money.

Some observers believe the "contra revenue" idea is a good one, and there are parallels in other companies. Dell (DELL) did something like this recently, sacrificing margin and bottom line for market share. Intel has also tried something like the contra-revenue plan before. In 2011, Intel created the $300 million Ultrabook Fund to seed the Ultrabook market. That program ended two years later, when Intel officially labeled it a failure.

Intel has a long history of success, but that success is based on the same reason all super-successful organizations succeed. These companies are designed to do something very well. Namely, what they are already doing.

Remember the demise of Kodak? The stunning collapse of that legendary company left many scratching its heads. Although Kodak defined itself as being in the imaging business, it was so deeply entrenched in wet chemistry technology it was unable to move to the digital technology.

While Intel is certainly a long way from anything like the fate of Kodak, it does face the same factors that undermined Kodak's competitive edge. The relentless pursuit of incremental profit is the hallmark of all mature organizations. That pursuit drives them to achieve tiny wins by leveraging assets.

No company has ever been able to compete successfully when a disruptive innovation enters the market by asking: "How can we do what we're already doing, a tiny bit better and a tiny bit cheaper?"

An Unexpected Bright Spot

In Intel's earnings release, apart from the PC Client Group and Data Center Group, almost all business segments reported an operating loss for 2013. Intel's data center business grew 8 percent to $3 billion, which was impressive, but Wall Street had hoped for double digit growth.

Intel's chips for consumer desktops were the unexpected bright spot. Intel's performance in the PC client group business was more stable than expected, and in a disastrous PC market, nearly flat revenue has to be considered something of a win.

Krzanich cited growth coming from mature markets, such as the desktop, as well as gaming platforms and the introduction of the Haswell-based NUC. Some observers might believe that contradicts the obvious point that the PC market is on the wane. I hope they do. Belief in some kind of new trend of a successful PC might prop up Intel's stock, allowing investors time to see if the company can actually buy itself a profitable piece of the mobile market.

The other strategy is to stand clear and wait for Intel to prove itself again. There are plenty of compelling opportunities in technology companies where the path to long-term shareholder success is much clearer.

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.