Intel Again
Bear Rebuttal

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Dueling Fools

By Rob Landley (TMF Oak)

It's tough critiquing one of America's most profitable corporations, especially one I actually do like and own shares of. What's more, I agree with a lot of what Brian has to say. Where we differ is interpretation, and the emphasis we place on things.

Yes, Athlon's been out for well over a year and Intel processors still outsell AMD. The limiting factor here is production capacity. Both AMD and Intel are selling all the chips they can make, with a backlog of orders that's likely to intensify as the holiday season approaches and the start of a new corporate fiscal year opens the door to new purchases.

The amount of market share AMD can take away from Intel in the processor business is limited by how many chips AMD can make. AMD is investing profits (and the revenue from its secondary stock offering) to expand its production capacity.

But saying Intel's processor market share is secure because AMD is still growing is a hard argument to make, especially in an industry driven by the 18-month product lifespans indicated by Moore's Law. Intel's processor leadership in the future is no longer assured. Intel realizes this; that's why it's hedging its bets and diversifying into networking, site hosting, and such.

Sure, Intel's margins are still fine. They even grew last quarter, which isn't surprising when you realize that, for the first half of the year, Intel couldn't produce some of its most profitable chips (Gigahertz Pentiums) in volume. Hence prices (and thus, margins) didn't come down because of a supply-side squeeze -- ironically meaning AMD had no incentive to lower prices without competition from Intel! When Intel got its high-end manufacturing kinks worked out and supply normalized, the change in product balance overcompensated Intel's margins back above Intel's own often-repeated target of 50-55%. But, I won't be the first to point out that AMD has benefited from all this at least as much as Intel has: It was producing Gigahertz-plus Athlons at full speed the whole time, and still is.

When I say increased competition and lower prices, I'm talking about a shift in the industry, not next quarter. Increased volume can make up for the lower prices, but only for a company that manages to capture that volume, which fighting to stay at the high end of the market just won't accomplish.

I'm not saying anything Intel doesn't already know. I first discovered Clayton Christensen's brilliant book The Innovator's Dilemma (a New York Times bestseller that tops BusinessWeek's "Frequently Recommended Titles" list -- my review of it for the Rule Maker Portfolio is here) because Andy Grove brought it to the attention of Forbes.

It was also Grove who called the Internet an "inflection point," and bought time with the Celeron to diversify Intel's business away from the all-eggs-in-one-basket microprocessor-centric model. Again, I'm not saying anything that Intel hasn't already enacted plans to react to, I'm just noticing a lot of inertia involved when a company this size tries to change direction, complicated by the nature of the problem facing the company.

My argument isn't that Intel has something wrong under the hood, it's a question of steering the vehicle through the terrain ahead. Sure, I have plenty of technical nit-picks, but they're merely symptoms of the larger problem.

Things like the company's slow and halfhearted adoption of the ARM chip design for embedded devices. (Never heard of it? Here's an article from almost two years ago.) ARM is a low-power chip that can compete head-on with Transmeta's Crusoe in low-power performance, and is a natural in cell phones and other portable devices. It's a great asset to the company; if it really believes in the age of Internet access devices, this should be central to its strategy. But, does ARM get even 1% of the fanfare Intel puts behind the high-end iTanium? Nope.

As for Intel crippling its Celerons with a 66 MHz front-side bus (less than 1/10th the speed of the inside of the chip) so as not to compete with its own high-end Pentium III chips (leaving Celeron outperformed by AMD's Duron)... go read what Tom's Hardware Guide has to say about it. I have to shake my head and sigh for a bit.

The lure of high margins distracting a company from what it needs to do to secure its future is what The Innovator's Dilemma is all about. If you don't have time to read the book, go read the February 1999 Forbes issue that had Andy Grove on the cover with the book's author. The disparity between what makes the most money today and where the money will be coming from tomorrow is a powerful motivating force for a company to do the wrong thing. Like a smoker addicted to nicotine, the lure of existing customers and high margins can lead a company to unhealthy behavior. IBM couldn't switch from the mainframe market to the PC until its old market collapsed and dragged the stock down 75% in 1992. Digital Equipment Corporation (DEC) never managed to change, and was a pathetic shell bought by Compaq only a few years after celebrating its highest profits (and margins) ever.

Intel knows all this. It's trying very hard to prepare for the future. It's painful to see them know what the right thing is and then get distracted. The Pentium 4 is aimed at systems selling for $2,000, when the selling price of midrange PCs has cracked the $500 mark and continues to sink. According to Moore's Law, that's two full generations away from the mainstream, assuming the mainstream stops drifting.

It does Intel no good to invade Sun Microsystems' (Nasdaq: SUNW) market if AMD eats into Intel's in the meantime. That's what did DEC in (chasing IBM's soft underbelly at the high end while Compaq was gobbling up DEC's core business). Silicon Graphics (NYSE: SGI) nearly went out of business over a similar debacle, distracting itself by buying Cray (Nasdaq: CRAY). Great companies all, by the way.

I'm here to remind everyone of the seven lean years, while the seven fat years are still here. Intel's trying to shape up for the future, but it's hard to nail your shutters closed in the eye of a hurricane when it's bright and sunny outside. Margins today are good, but they do not indicate what the future holds, and can easily distract you from it. Despite the sunshine, there is work to be done here.

P.S. Here's the link to Clayton Christensen and Andy Grove in Forbes again. Read it. It's really good.

You can read the book's first chapter on BusinessWeek's website here.

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