Intel Q2 Earnings: What the Numbers (and Management) Say

Intel Corp INTC reported first quarter earnings including intangibles amortization and restructuring charges of 55 cents, which were ahead of the Zacks Consensus Estimate of 50 cents on revenues that also beat by 1.2%. Shares gained 1.4% after-hours.

Our Take

The PC market and free Windows had sentiments at rock bottom going into the earnings, so Intel's modest beat was applauded by investors.

There was a significant reduction in the tax rate that wasn't explained, but the tax rate for the year was raised indicating that this isn't a change in the way it's doing business. Higher other income and a stronger gross margin also contributed to the results.

Of course the computing business could have done better. But consider that Gartner and IDC said shipments declined year over year by 9.5% and 11.8%, respectively while Intel's saw units down 10% with an ASP decline of just 3%. Intel's strategy appears sound in this case: get into as many devices as you can, even if they are low end and there will be an overall increase in market share and margin benefit from higher volumes. This is exactly what appears to be happening.

Management sounded optimistic about the mobile side of things but it's definitely a pain point. Granted that units are growing nicely (10 million tablet units in the last quarter), but the 4G SoFIA is now a 2016 story, which can't be so great. Intel subsidizes the tablet chips, so until the technology is up to speed, it will have to keep paying out to maintain/build market share. The $800 million cost cut plan for 2015 remains on track.

The plan is to get the PC business stable and focus on growth in data center, IoT and NAND. In the last quarter, this bucket grew 6.2% sequentially and 25.3% year over year, which looks pretty great. Management said that scaling down R&D was not a good idea because of the prospects in this business and there doesn't seem to be anything to complain about here.

And this brings us to the subject of yet another capex reduction. In explaining the billion dollar cut, Intel says that it's pushing out 10nm spending and running the 14nm process for another product (Kaby Lake). This will be a positive for margins (full-year gross margin guidance was raised).

But don't expect the 10nm Cannon Lake before 2H17 and the tick-tock cadence will now be over a 2.5-year period instead of 2 years. This may not mean that the competition will catch up because Intel is still ahead in the race. Although International Business Machines IBM has mentioned a 7nm chip, it is not expecting to ship before 2020. Moreover, there are many steps to volume production of chips and no one is as experienced at this game as Intel.

Altera ALTR: The big news is, Intel will help build out Altera's chips built on ARM designs with its advanced process technology! No one thought Intel would advance a competitor's business, but it appears that Altera FPGAs can pick up significant market share if it's the first on a technology node. This will also help to keep the fabs full, so good for margins. Intel will also integrate the two companies' technologies to create new product categories in the data center and IoT.

The numbers in detail-

Revenue

Intel's reported revenue was $13.20 billion, in line with the guidance range of $13.2 billion (+/-$500 million) and topping the Zacks Consensus of $13.04 billion.

The Client Computing Group that includes both PC and mobile continues to account for the largest chunk of Intel's business (57%). Segment revenues were up 1.6% sequentially and down 13.5% year over year.

Overall unit volumes were flat sequentially but down 10% year over year, with average selling prices (ASPs) increasing 2% sequentially and declining 3% from last year. PC and notebook units dropped a respective 22% and 11% from last year, offset by tablet unit growth of 11%.

Management said that the shrinking of inventory in the PC supply chain was not material and supply chain inventories remain at normal levels and better than expected. Internal inventories were down in units although they increased substantially in dollars because of a higher mix of 14nm products. They are excited about Microsoft's MSFT Windows 10 because its best features will work best with Intel.

The consumer side will take a hit this year, but Intel hasnt baked in a  lot of upside from Windows in its guidance anyway, so it is not expected to surprise negatively. Intel managed to grow high-end  product sales in the last quarter, but remains focused on increasing the volume of shipments targeting lower-end devices including most of Google's GOOG Chromebooks as well as other devices from hardware makers like Hewlett-Packard HPQ, Dell, Lenovo and other Chinese players.

Mobile is going as planned, SoFIA 4G will ship first half next year. The plan is to get the CCG business to stabilize while focusing on growth in other areas.

Data Center, which generated 29% of quarterly revenue, saw both units and ASP grow 5% from last year. Segment revenue was up 4.6% sequentially and up 9.7% year over year.

Management said that Intel remains on track to deliver 15% growth for the year (they did 19% in quarter 1). The weakness in the last quarter was on the enteprise side, as companies remain cautious about spending (no commentary on FX though that is also likely a factor). This weakness will continue through the year, but continue to be offset by strength in the cloud (driven by consumer services), network virtualization (includes network workload migration to Intel architecture), network function virtualization, SDN and storage.

The relatively new segment Internet of Things Group, which also includes Intel's embedded business segment accounted for 4% of revenue, growing 4.9% sequentially and 3.7% from last year.

Management said that expectations for the year were proving overly optimistic.

The Software & Services Group generated another 4%, flat sequentially and down 2.6% year over year. McAfee continues to lose market share.

Management said nothing much.

The Other segment, jumped 16.3% sequentially and 38.3% from last year although percentage contribution to revenue remained at 5%, as Intel's NAND business grew more than 40%.

Management said that NAND was benefiting from increased adoption in the cloud and compute customer wins in China. Intel has a value proposition with next-gen products (3D NAND) that it developed jointly with Micron MU and believes that the architecture used will give it cost, yield and performance advantages over the competition. Management provided limited color about the expected ramp up in the second half except that it remains on track.

Margins

The gross margin for the quarter was 62.5%, up 203 basis points (bps) sequentially and down 196 bps year over year, better than the guidance of 62% at the mid-point. Seasonality was positive in the sequential comparison. Also, the highest-margin data center business continued to grow and IoT also expanded margins sequentially. NAND losses are also coming down.

So all these in combination is making for a stronger mix. Lower utilization of 22nm process and increased use of the maturing 14nm process were other positives. The contra revenue or subsidy that Intel is giving tablet makers for the higher cost of using Bay Trail remains an offsetting factor, but management is on track to realize $800 million cost reduction through the year. A third of this has been realized and the rest has been left for the back half. 

Operating expenses of $5.10 billion were up 1.9% sequentially and 2.2% from last year. The operating margin was 23.8%, up 255 bps sequentially and down 455 bps year over year. R&D costs were lowered during the quarter by 4 bps and remained 272 bps above year-ago levels. MG&A costs were down 51 bps sequentially and 13 bps from last year.

Segment margins showed seasonal improvement— Client Computing 21.3% (up 225 bps sequentially, down 841 bps year over year), Data Center 47.9% (up 163 bps and down 462 bps, respectively), Internet of Things 25.9% (up 192 bps and down 115 bps, respectively) and Software & Services 2.6% (up 206 bps and down 85 bps, respectively). The Other segment continued to make significant losses.

Net income excluding restructuring charges was $2.95 billion, or 22.4% of sales, compared to $2.10 billion, or 16.4% in the previous quarter and $2.88 billion or 20.8% in the comparable prior-year quarter.

Including restructuring charges of 5 cents a share, the GAAP EPS was 55 cents in the last quarter, up from 41 cents in the previous quarter and consistent with the 55 cents in the year-ago quarter.

Balance Sheet

Inventories were up 9.1% sequentially with annualized inventory turns moving from 4.6X to around 4.1X. Days sales outstanding (DSOs) went back up from 23 to around 27. The cash, marketable securities and fixed income trading asset balance at quarter-end was $13.87 billion, down $248 million during the quarter.

Intel has $12.11 billion in long-term debt and $1.12 billion in short-term debt, resulting in a net cash balance of $636 million. Cash flow from operations was around $3.4 billion. Important usages of cash in the last quarter included $1.77 billion on capex, $1.15 billion on dividends and $697 million on share repurchases and $467 million on acquisitions net of cash.

Guidance

Intel guided to third-quarter revenue of around $14.3 billion (+/-$500 million), up 8.4% sequentially and down 1.7% from the Sep quarter of 2014 (slightly better than the consensus estimate of $14.08 billion). The gross margin is expected to be around 63% (+/-2 percentage points). R&D and MG&A expenses are expected to come in at around $4.9 billion. Restructuring charges are expected to be around $175 million.

Management also expects to provide for depreciation of around $2.0 billion and intangibles amortization of around $70 million. Other income/expense and equity investments are expected to result in a net gain of $100 million. Applying the guided annual tax rate of 26% and excluding restructuring charges from calculations, net income comes to around $3.06 billion or 21.4% of revenue, which would be up 3.7% sequentially but down 8.2% from the year-ago quarter.

For 2015, Intel expects revenue to be down 1% (previous approximately flat), a gross margin of 61.5% (+/-2 percentage points) (previous 61% at the mid-point), opex of $19.8 billion (+/-$400 million) (previous $19.7 billion), intangibles amortization of $265 million (previous $250 million), depreciation of $7.9 billion (+/-$100 million) (previous $8.0 million), a tax rate of 26% (previous 25%) and capex of $7.7 billion (+/-$500 million) (previous $8.7 billion).

Intel shares carry a Zacks Rank #3 (Hold).

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