Intel Clears the Decks In Advance of Haswell (INTC: NEUTRAL)

Intel  came it a bit shy of expectations for 1Q, but that was likely a relief for many, and its 2Q guidance is close enough to expectations and its capex trim is likely to reassure investors that it has no intention to flood the market with CPUs.  New CPU releases appear on schedule, gross margin is positioned for recovery in 2H, and data center business is seeing continued strength from cloud and HPC and also a hint of a pickup in enterprise spending. Uneven macro signals leave 2H demand in a fog, and so we think it premature to raise growth estimates, but Intel is taking a cautious approach and this should limit downside risk.

Results: Intel reported results slightly below expectations, as we expected, on in-line revenues and gross margin at the low-end of guidance. Revenue came in at 12.6B and EPS was $0.40 (vs. $12.6B and $0.41 consensus) as PC Client revenues fell 6.6% Q/Q and data center revenues fell 6.9% Q/Q.

Guidance In Line: Intel expects a step-up in sales this quarter as last quarter’s inventory clearing ends and this quarter sees a slight inventory restocking to support the Haswell release. But slightly higher OpEx, higher taxes, and lower Other Income together push GAAP EPS implied by guidance down $0.02 to $0.36, below consensus views of $0.40, (on in-line sales of $12.9B); Intel continues to expect low-single-digit growth for the full year.

• Surprise: Signs of Life in Enterprise Spending: Enterprise segment is beginning to improve and appears to be growing by a small amount Y/Y (as cloud and HPC drivers deliver Y/Y growth).

CapEx A Bit More Cautious: Because unit demand was a bit softer for older products and orders stronger for upcoming CPUs, Intel took capacity offline, and is pulling some  22nm tools into 14nm manufacturing (for Haswell). This acceleration in the shift to next-generation processing—which  was used successfully in 2009—leads to capital savings of $1B (to make capex $10B in 2013, ex 450mm spending) and positions Intel for that jump in gross margin in 2H13.

• Is Intel Going to Overbuild? Not Very Likely. By taking capacity off line on older technology, Intel adjusted to the weaker PC environment. It also made it clear that it has yet to settle on the level of capacity it will put in place for 14nm. We have picked up signs that Intel has pulled 14nm tools away from its Arizona fab for use instead at D1X. It looks to us like Intel is focusing efforts until it sees whether macro recovery warrants further line installations.
• Ramp also designed to support growing Foundry activities. Design wins take 2-3 years, and we have learned only of the first (Altera).

Full Year View Not Very Aggressive: Intel is counting on very little when it comes to PC demand this year—“flattish-to-up-a-smidge”—but it continues to see double-digit growth in its data center business. If emerging markets pick-up, this view on PCs could prove too conservative.

• The second half remains clouded and uneven economic data undermines forecast precision. Emerging markets remain under-penetrated by IT equipment – both in businesses and in households. And while tablets are being found to be the much better companion for content consumers and some professional activities, households still want to get that first PC so the kids can do homework. Should macro recovery continue even fitfully to gather speed, unit sales are likely to outpace expectations.

Gross Margin Has 2H Solid Drivers: While PC drivers remain weak for 1H13, Intel is set to ramp new CPUs for PCs (14nm Haswell) and mobile devices (22nm Atom-Bay Trail platform) over the next few months, while the server Romley platform is scheduled to be refreshed with Ivy Bridge CPUs. Look for the move to 14nm mainstream products to help nudge Intel’s GM higher in 2H, but be aware that Intel plans a slower ramp than usual for Haswell (as we discovered recently in Taiwan discussions).

Longer –Term Potential: This 1H sees Intel’s release of Bay Trail (shipping this quarter), which marks the first serious step for Intel into tablets, hybrids, and convertibles in our opinion. It brings twice the performance of its predecessor and greater power efficiency – which, for the first time, will allow fan-less designs on an Intel platform.  And it is designed for touch-enabled, entry-level devices with prices starting at $300-$499 and possibly moving to $200. These are set to debut in late 2013 and Intel now will have a solution appealing both to  Windows and Android platforms (which comprise half the 190M unit tablet market). We do not expect major market share gains since Bay Trail arrives late in the year, but it is a start and should serve to establish a foothold for Intel in this fast-growing segment. Once Intel moves Atom to 14nm, where shrink and better designs should permit smaller die sizes and lower prices, device OEMs may be able to create affordable and power efficient devices with a richer experience than those based on ARM. We view Bay Trail as still an interim stage in Intel’s transformation into a more diversified CPU provider. In our opinion, it needs further power savings and cost reductions to make Intel-based tablets and hybrids competitive with best-of-breed offerings from Apple and Samsung.

Estimates:

We expect 2Q sales of $12.9B and EPS of $0.38; for 2013, we see $53.44B driving earnings of $1.84 per share.

Recommendation:

We remain NEUTRAL on INTC in the face of weak PC demand in 1H and persistent uncertainty regarding 2H. Positive drivers include growing demand for cloud infrastructure, opportunities as a leading-edge foundry, launch of higher-performance, lower-cost ICs in June.