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Posted 10/20/2003
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Intels good news is not nearly so good
A closer look at the chip giants earnings shows that, outside Asia, business isnt growing all that fast. And the market is missing the big threat posed by Advanced Micro Devices.
By Bill Fleckenstein
Intel reported its third quarter results last Tuesday. The dead fish who are paid handsomely to analyze these numbers went about their usual cheerleading and considered it a day's work.
This week, you can decide yourself what you think of their efforts by getting to the innards behind Intel (INTC, news, msgs). Nothing like a little scrutiny to throw a damper on speculation.
Intel's dubiously credible pedestal
As regular readers of my daily Market Rap know, I have long been bearish on Intel, for four fundamental reasons:
- The no-growth nature of the personal computer market.
- What I believe to be Intel's faulty strategy of selling high-end parts to a market that no longer needs them.
- The tremendous advances made by Advanced Micro Devices (AMD, news, msgs) in the 64-bit arena. (Catalyst-wise, this is the most important reason of all.)
- Intel's wildly optimistic valuation.
By way of preface, Intel's third-quarter results were as they were largely due to chip sales to China. I did not anticipate these sales, but after becoming aware of them recently, I knew that Intel would have a big quarter. (I eliminated my short position so I could sell last Wednesday's party if I liked what I saw. I did, and I did.)
Nonetheless, I believe the bulls are now mistakenly falling all over themselves to extrapolate a quarter that shouldn't be extrapolated. Further, I believe they're completely oblivious to the competitive threat of AMD, as well as other problems. Let me offer supporting data.
Clarity, via year-over-year scrutiny
First, let's look at Intel's revenues year-over-year, rather than sequentially. That will give us the best picture of its "improvement" over a longer timeframe and over a weak period. Intel's revenues grew year-over-year from roughly $6.5 billion to $7.8 billion, a gain of about $1.3 billion. When you look at Intel, remember that it's essentially a brick factory. After the company produces enough bricks to pay all its costs, the revenues from each incremental brick basically fall to the bottom line.
You can see that is clearly what happened. Intel's operating income (like its revenues) was up about $1.3 billion. Net income was up just about $1 billion, as incremental sales are immensely profitable. That's the beauty of a high-fixed-cost business. I often like to invest in such businesses, especially those with a barrier to entry, for exactly this reason. However, as I'll explain, Intel's barrier is being breached, which is the source of its biggest problem.
As for the growth that drove those revenues and profits, year-over-year sales in the United States grew from $2.095 billion to $2.168 billion (which is to say, not much). Europe did a bit better, with revenues growing from $1.505 billion to $1.683 billion. Not bad, but nothing to get tremendously excited about.
Ex-China, the chimera of growth
However, revenues in Asia/Pacific, namely China, grew from $2.489 billion to $3.266 billion. Forgetting the percentage growth for a second, this was an obviously chunky gain of some $800 million -- about 61% of Intel's overall year-over-year growth. Japan provided the other serious upside, as revenues grew from $415 million to $716 million, providing a little better than 20% of total growth. The bottom line: Asia and Japan accounted for more than 80% of the revenue gain year-over-year, and likewise, 80% of the profit gain year-over-year.
What's interesting to note is that, for all the hoopla about the tech boom supposedly set for the United States, one can see very little growth there. If folks think the new Centrino mobile technology has really helped Intel, the company must be facing pretty serious average selling price pressure in its basic business. This is an important point. In the past, AMD has been an also-ran; it was only able to compete on price, since what it made was a "me-too" product. That put margin pressure on Intel from time to time.
But, in the last quarter, the company has become more focused on its 64-bit Athlon and Opteron products and has not been in Intel's face as much. As a result, Intel enjoyed a temporary sweet spot from competitive pricing.
Further, we know that Hewlett-Packard (HPQ, news, msgs), for one, has built up inventory. Interestingly, Intel admitted on its call last Tuesday night that inventories were building in the distribution channel and on its own books. (Of course, when inventory builds on Intels books, it has the added effect of helping to boost gross margins. Thats because its cost of goods sold is spread out over more parts, even though some of those parts are sitting on the balance sheet.)
The fact that there's little combined year-over-year growth from America and Europe -- even with the special circumstances of inventory-building by Hewlett-Packard and perhaps others, the tax rebates, big government spending, etc. -- is especially noteworthy. It indicates that there is still no surge in demand.
Bulls extrapolating in a China shop
So where does that leave us? Of the 25 cents a share that Intel made, approximately 9 cents was incremental profit from China. Said differently, if China had stayed flat with last year, Intel would have made about 16 cents. The bulls have basically extrapolated the results from China into the future. Theyre assuming good things will happen everywhere else, even though there's scant sign of that, outside of a nice pickup in Japan.
To repeat, we know that Intel has admitted to some inventory-building that it can see, but it does not have good visibility in the end markets. It's difficult to get a handle on what might be happening in China, but we know for a fact that China has a boom going, and potentially bubble-like conditions. The growth rate of Chinas M2 money supply is now more than 20% year-on-year, as the Chinese central bank prints yuan to exchange for the dollars it receives from Chinese exporters. Its trying to peg the yuan at a constant value against the dollar.
The cell-phone vendors have pointed to quite a good inventory build in China. (A whole bunch of cell-phone vendors think they'll gain some decent amount of market share. We've got a humongous inventory build in cell phones, specifically for the Chinese market, but that's another story.) Judging from the news and what takes place in that kind of environment, it would not be surprising to see inventory-building occurring in PCs as well. If so, extrapolating China and capitalizing it into the market cap of Intel will turn out to be dangerous indeed.
AMD tarries at Intel's barrier to entry
However, the problem doesn't stop there. The real problem for Intel, other than its flawed "business model," is what's coming from Advanced Micro Devices. AMDs high-end chip is superior to Intel's; witness the contracts awarded to AMD by all the high-end supercomputing labs. For the first time ever, Microsoft (MSFT, news, msgs) is writing software specifically for AMD's part. (Microsoft is the publisher of MSN Money.)
The gamers, who are the real performance judges, are wild about it. We have yet to see a major PC vendor such as IBM (IBM, news, msgs) or Dell (DELL, news, msgs) endorse the product, but other PC vendors have quietly done so. I believe it's only a matter of time before both IBM and Dell endorse AMD's part. Dell has basically said this already. It's just waiting for the market to develop and for the greater availability of parts.
To repeat, my bearish stance on Intel since midyear has been based specifically on the weak end markets, the competitive threat posed by AMD and Intel's crazy valuation. I would be the first to admit having missed the Chinese boom and potential inventory build. But it is what it is.
Inclement weather for incremental revenues?
To revisit my brick-factory analogy, if AMD takes away orders or forces Intel to lower prices, Intel's revenues and bottom line will fall, just as incremental revenues quickly became profits this quarter. That 25 cents per share could quickly shrink to 15 cents or less. I believe that will eventually happen. If my view of the economy is correct, Intel will be lucky to turn in 10 or 12 cents a quarter in a few quarters. In my opinion, a company with little growth in the end markets, and one that faces a serious competitor, cannot support a price-to-earnings multiple much over 15 to 20 times, even being generous. That would take the stock from todays $32 to $8 to $10, which I believe is ultimately where Intel is headed.
But even if Intel were able to annualize these gains, why, in light of the previous discussion, should it be worth more than, say, $20? (If I am wrong about this, it will be because AMD coughs up a hairball, but that's not what I expect. Based on its results reported last Thursday, AMD looks to be on track.)
From here, Intel looks to me to have nothing but downside in front of it. But given that we're in the middle of a speculative frenzy, the stock will continue to go up as long as it stays in motion.
Shirk-work vs. homework
Speaking of the crowd that helps keep it aloft, the dead-fish community might yet wake up and smell the coffee, realize that Intel's days as a price-dictating juggernaut lie in the past, and get to see what a real paradigm shift looks like. For now, however, dead fish continue to "earn" their millions of dollars by donning cheerleader costumes while delivering off-the-mark "analysis" to justify the hyping.
Meanwhile, I hope my analysis offers readers a useful, real-time counterpoint to the arm-waving that pervades the current speculative environment. Rather than succumbing to that, you can put this basic analysis to good use. Intel is such a simple stock to analyze. You can do your own math and figure out what you think the company really can earn, and what it's worth.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckensteincapital.com site. At the time of publication, Bill Fleckenstein was short Intel. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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