Will it Take a Liquidity Crisis for Intel to Rationalize Capital Spending?

Includes: AMD, INTC
by: William Trent, CFA

We've been harsh critics of the semiconductor industry's "build it and they will come" attitude, noting that a significant slowdown in industry growth began in the mid-90's (before the tech bubble).

Software is in the same boat, but companies have been much more rational about how to deal with it. While they still introduce new products and features, Microsoft (NASDAQ:MSFT) is returning wads of cash to shareholders and Oracle (NYSE:ORCL) is using its cash for acquisitions. Both strategies take capital out of the industry and thus allow existing returns to be spread over a smaller capital base. Presto! Returns on capital improve.

Although some semiconductor firms, such as Linear Technology (NASDAQ:LLTC), appear to have gotten the message others will change their ways only by force. Case in point: microprocessors.

Intel certainly isn't going to let up any time soon.

Today's product leadership is built around our 65 nanometer technologies and we are well along the path to introduce products based upon 45 nanometer technology later this year. To that end, we've announced the use of breakthrough materials in our 45 nanometer process that will allow us to introduce faster and more power-efficient microprocessors to pack more features into smaller die.

(Excerpt from full INTC conference call transcript)

With $8 billion more cash than debt, Intel can sustain irrational levels of investment for an extended period. By contrast, Advanced Micro Devices (NASDAQ:AMD) is running a little low on cash. Not surprisingly, they are getting supply/demand religion:

Among the efforts already underway are: reducing 2007 CapEx spending by approximately $500 million, largely by slowing the rate of the fab 38 conversion; we are reassessing our overall staffing plans, specifically we are going to limit ourselves solely to critical hires, and to the extent that we add resources, we will focus primarily on doing so in lower cost geographies.

(Excerpt from full AMD conference call transcript)

Intel put a spin on the damage they have done, saying:

Gross margins for the quarter was better than we expected and we can report excellent results over the last year in cutting spending, which is $0.5 billion lower than the first quarter of 2006.

Looking beyond the transitional second quarter, we see an improving second half as the distinctive products and process technologies catered date. We expect gross margins to improve significantly in the second half with a percentage in lower 50's range and we have raised our forecast for the full year....

Gross margin dollars were $4.4 billion, $378 million lower than the fourth quarter. Gross margin percentage of 50.1% was above the midpoint of our forecast and 0.5% higher than the fourth quarter.

(Excerpt from full INTC conference call transcript)

The raised guidance is to 51% gross margins - plus or minus a few points. In 2005 Intel's margins were 60%. 10 percentage points of margin were lost because they kept building capacity that wasn't needed - why do they continue? To hear them tell it, it is because the margins will improve once they ramp up on the new technology.

Chris Caso - Friedman, Billings Ramsey
Hi thank you. I wonder if you can give some detail on what impact we might expect from the introduction of the 45 nanometer product in the second half, specifically on gross margin impact, you talked about 25% smaller die size, do you expect that have any material effect on gross margins this year and if not maybe you can talk a little bit about what we might expect in the 2008?

Andy Bryant
When you start a new process you typically have a little bit of variation, and it comes with it because you have the start-up cost that you're dealing with now. Then before the product gets called you have the pre-quality reserves and then you’re quick valuing at a point in time. So, when we get into the Q2, I will give a better forecast of when those products may qualify and when you might start to see the inventory being valued and the costing marginal effect. So, I guess, I am telling you, I am not going to give you many specifics about that. Yes, we think the cost envelope for those products can be very competitive, we feel pretty good about where those are headed.

(Excerpt from full INTC conference call transcript)

The thing is, investors can only hear that so many times before they stop believing it. Here is what Bryant said in the Q2 2006 conference call:

Andy Bryant
Thanks, Paul. The second quarter was the time for facing the challenges of the market, while moving ahead with plans to improve our products and capabilities. Competition, market softness, a product mix shift in customer inventory levels entering the quarter, were among the challenges.

In growth and servers, chipsets for mobile computers and communications infrastructure were among the bright spots.

While we have trimmed the outlook for gross margin for the year, we continue to tackle the cost structure with reductions in capital spending, R&D, and headcount. We have also reduced our level of cash and the number of shares outstanding.

As Paul stated, we made excellent progress in pushing forward with new products to support a stronger second half.

(Excerpt from full INTC Q2 2006 conference call transcript)

The second half came and went. Just as we expect the second half of this year to come and go without the relentless investment in new technology paying off. We just hope it doesn't take a liquidity crisis before Intel finally comes to its senses.