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Pentium II prices to continue downward

Processor prices are nowhere near rock bottom, analysts say, and will continue on their downward trajectory because of innovations coming from Intel.

Desktop and processor prices are nowhere near rock bottom, analysts say, and will continue on their downward trajectory because of upcoming innovations and product shifts from Intel (INTC) as well as a more competitive marketplace.

Although the company said that its overall profit margins would decline to 55 from 60 percent next year in a conference call with analysts yesterday, observers believe that the company has more room for price movement than the projected decrease might indicate.

The decline in margins, said many, comes as a result of the new additional chip packaging that comes as part of current Pentium IIs. The gross margin on the microprocessor core remains close to, or above, 80 percent, analysts said today.

By removing the pricey packaging on some processors and introducing new high-end chips--both of which will occur in the second half of this year--Intel can effectively maintain its average selling prices (ASP) and subsidize steeper discounts on processors and hence completed desktops--the latter a boon for users. In turn, such discounting would force other processor makers, and computer makers, to follow suit.

(Intel is an investor in CNET: The Computer Network).

"The gross margin issue is a product transition issue," said Ashok Kumar, an analyst at Loewenbaum & Company. "ASPs will stay the same in 1998."

The product shifts that will fuel the cuts will occur in the year's second half, after Intel releases the "Deschutes" processors, the next generation of the Pentium II.

On the low end of the Deschutes line, Intel will jettison much of the expensive, fancy packaging. New, low-end Pentium IIs will use a more simplified circuit board and not contain additional "cache" memory, said Nathan Brookwood, semiconductor analyst for Dataquest. Cache memory is used to bridge the gap between the speed at which the processor operates and how fast memory can feed it with data.

In addition, a fourth-quarter release of Deschutes will eschew the "Slot 1" cartridge and use a chip package similar in concept to the older Pentium, added Kumar, saving further costs. Intel executives have themselves admitted that the Slot 1 architecture could vanish on low-end Pentium II chips.

On the high end, the company will release a new generation of pricey server chips that will likely raise margins and average selling prices.

In the end, if the transition succeeds, these forces should allow the company to maintain its overall profitability while simultaneously prompting desktop cuts.

"In the second half, a Pentium II will cost what a Pentium costs today," said Brookwood. Prices could drop to, or below, $100, compared to the cheapest Pentium II chip today, priced at well over $200.

"I expect to see Intel's prices pressured more this year than last, but they are also going to be introducing new server chips. These will sell for about $2,000. That makes up for a lot of low-end pressure."

Historically, the company has used new, high-priced chip lines to perform this same trick. Intel engaged in steep price cutting this past year. However, the ASP was effectively the same as it was in 1996, said Brookwood, and sales also went up.

In 1997, Intel shipped close to 80 million microprocessors, which garnered approximately $18.3 billion in revenue.

While these product changes may allow Intel to achieve lower prices in a relatively painless manner, the level of competition will become increasingly difficult to deal with, said others.

"Blended ASPs for Intel processors will likely decline further in 1998 before they show any sign of stabilizing," said Charles Boucher, semiconductor analyst with UBS Securities. "In 1996, they didn't have much competition and Pentium prices remained high. In 1997, a combination of competition and the popularity of sub-$1,000 forced prices down."

In contrast to Brookwood and Kumar, Boucher said that there is actually a strong chance that Intel has already reduced its gross margins on processor cores, meaning that Intel is not waltzing unscathed through these market shifts.

The public's demand for inexpensive computers will continue to grow, he added, a phenomenon which appears headed to change the dynamics of the industry.

"The market has undergone a behavioral change. You'll see inexpensive mobile machines and simpler machines in the corporate market," Boucher predicted. "Customers are asking themselves what they need rather than blindly buying the top-of-the-line processors."