Pentium II shift hurts Intel earnings

Intel (INTC) has got to go down before it can come back up.

Analysts say Intel's recent introduction of the Pentium II processor has actually hurt the company by cutting into the sales of its previously mainstay chips. They blame this market cannibalization for today's announcement that second-quarter earnings will be lower than projected, leading to a decline of more than 12 percent in Intel's stock.

And it isn't clear how long it will take the company to recover. Revenues for the leading chipmaker's second quarter are expected to drop 5 to 10 percent below its first quarter's $6.4 billion.

The company's gross margin, a key measure of profitability, is forecast at less than the 64 percent of the prior period, Intel said. The company had previously projected that the second quarter of 1997 would be flat or slightly up from first-quarter revenue of $6.4 billion.

At least five brokerage houses trimmed their ratings on the giant chipmaker this morning after Intel issued a warning that quarterly revenues and net income wouldn't match current forecasts.

The company said that demand is low, particularly in Europe. But it's not the first time Intel has experienced this phenomenon.

Historically, whenever Intel introduces a new line of processors, there is a temporary lull in demand for the old chips. Corporations, in particular, tend to slow their purchases of the older chips.

Analysts describe the current cycle as such: Client demand for older Pentium chips has slowed, and the newer MMX Pentiums and Pentium II chips still are not ready in any real volume.

"New chips are more in-demand than old chips. This is just a product transition. There is no change in PC demand. This is just an execution problem and this gives the competition a short-term advantage," said William Kurtz, an analyst with H.G. Wellington.

While this is something that Wall Street might have seen coming, that doesn't mean that investors were happy about today's announcement. Right after the bell this morning, Intel stock dropped about 25 points from yesterday's close of 163-49/64. It later gained back half those losses to close at 151-1/2.

Trading was very heavy, at 6.6 million shares in the first ten minutes. Intel shares remained the most heavily traded stock on the Nasdaq all day, with more than 53.5 million shares changing hands.

The markets as a whole were also hit hard in early trading: The Dow Jones Industrial Average was off 88 points, and the Nasdaq dropped 50 points. Both have recouped their losses.

Bruce Lupatkin, research director at Hambrecht & Quist, said today's announcement was predictable and that the disruption on Wall Street simply reflects the skittishness of the market.

"It is euphoria to doom and gloom," Lupatkin said. "Shoot first and think about it later," he said about the heavy-volume trading of Intel shares.

Lupatkin added that Intel has been trying to unload its older products overseas, but that inventory has now accumulated in some of its foreign markets.

The company said its newer products, including the Pentium processor with MMX technology and the Pentium II processor, are experiencing strong demand.

Some analysts think Intel could have made the transition more smoothly if it had anticipated the strong demand for chips with MMX technology. Morgan Stanley analyst John Marren said the chip company was not able to meet the strong demand for MMX chips, leading to the shipment shortfall.

Certain versions of the Pentium processor and all Pentium II processors have the MMX technology, which is used to speed up multimedia software. Older versions of the Pentium, often referred to as "classic" Pentiums, do not have MMX.

"They're making too many [classic] Pentiums and not enough MMX. The mix [of classic and MMX Pentiums] does not meet the market need," Marren added.

He has downgraded Intel to "outperform" from "strong buy." He also cut the 1997 estimate to $8.20 from $8.90, and the 1998 estimate to $9.85 from $10.50.

He estimates that Intel is looking at a million-unit shortfall because of the product mix problem. But he still expects Intel to compensate in the second half of the year and "pleasantly surprise" the market. Marren forecasts that Intel will ship about eight million Pentium II processors by the end of the year.

Intel itself expects to make up for the shortage soon. "We're ramping these products as fast as possible. We can't make the Pentium II fast enough to meet demand. But that is fairly typical with a new product cycle. We're moving as fast as we can," Intel's Waldrop said.

Waldrop said the lawsuits with Cyrix and AMD over the use of the term MMX did not affect second-quarter production schedules.

He would not comment on another recent lawsuit, this one filed by Digital Equipment, in which Intel is charged with "willful infringement" of ten Digital patents related to its microprocessors.

Some analysts question whether the competition, AMD and Cyrix, can take advantage of Intel's problems this quarter.

Mark Specker, an analyst with Soundview Financial, said the competition is in the same boat as Intel--everyone is trying to increase production. AMD and Cyrix will be able to gain from this situation if they have the products on hand right now. But, he added, once Intel is up to speed, they will be pushed back to the edge of the ring.

In the meantime, financial analysts are busy revising their estimates for the upcoming quarter and the fiscal year.

Wall Street had been expecting the chipmaker to report profits of $2.16 a share, according to First Call.

Merrill Lynch analyst Tom Kurlak, for example, reduced his second-quarter estimate to $1.81 from $2.22, and his 1997 estimate to $8.90 from $9.45. His 1998 estimate was kept at $11.20. Merrill Lynch kept the stock rated at "near- and long-term buy."

Intel is an investor in CNET: The Computer Network.

Reuters contributed to this report.