Why Intel is poised to soar

By Robert Walberg

The latest earnings report by Intel (INTC, news, msgs) is a case where investors need to look past the headlines.

That's because the headline numbers aren't pretty. Quarterly net income plunged 40% from last year on a 5% drop in revenue. Gross margins of 49.6% were in line with guidance but well below the 55%-to-60% range that used to be normal for the giant chip maker. Earnings per share of 26 cents exceeded Wall Street estimates by a penny. But that isn't the stuff of legends, especially not for an industry leader such as Intel.

• Video: Intel profit down 39%

However, Intel's numbers aren't as bad as they seem. The company is in an aggressive price war with upstart Advanced Micro Devices (AMD, news, msgs). Though it took a long time for Intel to concede that AMD is a worthy opponent, it looks like the company finally took a page from Sun Tzu's "Art of War" and has adopted the following principle: "Do not depend on the enemy coming, but depend on our readiness against him. Do not depend on the enemy attacking, but depend on our position that cannot be attacked."

Winning the war

In other words, Intel needed to stop looking over its shoulders and worrying about what AMD was doing or going to do, and start worrying about designing and producing the best possible product at a competitive price. If it succeeded -- with its resource advantage, failure would be difficult -- then the war with AMD would be won.

From this vantage point, the news from Intel is actually encouraging. The company has unveiled a slew of new products over the past several months that have helped the company modestly boost the average selling price of its chip sets. By contrast, AMD warned a few days ago that its profit would be well below expectations in part because its average selling prices were down "significantly."

What does this tell us? It looks like AMD is being forced to slash its prices in order to meet sales growth targets against Intel's revamped product line. Meanwhile, Intel is poised to use pricing pressure and a more favorable product mix to take back share.

Margins might not get back to the 55%-to-60% area anytime soon -- management conceded as much when it guided current quarter margins to 50%, plus or minus a couple points. But that's OK, at least in the short term. Intel's more aggressive approach toward the competition means that it will have to invest more in keeping its product line fresh, fast and functional.

The worst is over

It doesn't take a math genius to compute that increased capital spending and competitive pricing isn't the formula for margin growth. Nevertheless, it is a formula for resuming the leadership role in the microprocessor market.

As far as added development costs are concerned, Intel has taken steps to offset the impact of these moves on the bottom line by streamlining operations. For example, the company reduced its head count over the past six months by roughly 8,400, or nearly 8%.

Consequently, it's safe to assume that the worst is over for Intel when it comes to margin pressure and share losses. Toss in the much-delayed but important launch of Microsoft's (MSFT, news, msgs) new operating system, and the growing demand for its new dual-core and quad-core processors, and Intel could very well be at the threshold of another strong upturn in business. (Microsoft is the publisher of MSN Money.)

Heaven knows investors have waited a long time for the stock to turn higher (Intel would need to rally by more than 50% just to get back to where it was trading a few years ago). Nevertheless, it is up about 33% since bottoming out last summer. Once investors look past the disappointment of the headline numbers and see that Intel is actually winning the war against AMD, the stock should climb higher still. Don't expect a smooth ride, but, barring any setbacks, Intel should test the $28-to-$30 area over the next year.

At the time of publication, Robert Walberg did not own or control shares of any company mentioned in this article.