Intel's New Business Partners

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Moore’s Law, the theory that explains that the density of transistors on integrated circuits doubles every 2 years or so, is supposed to end at some point. For now, with mobile computing devices and smartphones booming in popularity, the demand for smaller more energy-efficient chips is spurring development. It’s also prompting consolidation in the semiconductor manufacturing industry, causing even heavyweight competitors such as Texas Instruments to drop out of the mobile processor business.

On the other hand, Intel (NASDAQ: INTC) is leading the way in developing technologies to produce the smallest possible chips. The company is set to release 14 nm designs (1/4 the size of the chips used in the iPhone 5) next year, and even opened its foundry to fabless semiconductor companies earlier this year.

While Intel’s newest business presents a great opportunity for a lot of companies to gain access to leading-edge technology, it’s not so clear if the opportunity is as great for Intel.

Conflict of Interest

Intel’s biggest competition these days comes from England’s ARM Holdings (NASDAQ: ARMH). ARM operates slightly differently from Intel. Instead of manufacturing the chips it designs, the company licenses its designs to companies like Apple (NASDAQ: AAPL) and Qualcomm.

By opening its foundry doors to the other companies, Intel will either have to turn away business opportunities, or manufacture chips designed by its competition. This creates a conflict of interest. If the company does decide to start fabricating ARM designs for customers, it will need a big boost in revenue to make up for the lost competitive advantage it creates. I believe that successful scenario is very unlikely for the company. For now, Intel is working with small privately held companies, none of whom competes directly against Intel.

Next Opportunity

Recent rumors have it that Intel is currently in talks of taking some Apple’s business from Samsung. A contract between the two companies would have Apple including Intel’s x86 processors in the next generation iPad. The deal would give Intel the in it has searched for in the mobile computing industry. However, it would require Intel to continue manufacturing ARM chips for the iPhone.

What’s more, I believe it’s very unlikely Apple takes its work to Intel in the first place. When Apple leaves Samsung, it will likely take its fab work to Taiwan Semiconductor (NYSE: TSM). The two companies already have a relationship, as Taiwan Semiconductor was tapped to produce prototypes of Apple’s new A6 chips. Apple’s current designs don’t yet require the leading-edge 22nm and 14nm processes provided by Intel. Taiwan Semiconductor’s 28nm process will work just fine for now. Moreover, Taiwan Semiconductor will keep costs lower compared to Intel.

The day may come when Intel’s foundry offers a value proposition Apple can’t do without, but I don’t think it’s within the next year. At that point, Intel will have to reexamine if a deal with Apple is worth it to them. If it has found success breaking into the mobile world with some other device, the appeal of iPads with x86 processors isn’t as great for the company.

More likely, a company such as Xilinx (NASDAQ: XLNX) or Altera, that designs FPGAs is the next customer for Intel Foundry Services. These companies do not compete directly with Intel’s microprocessor business, and could both benefit from the Intel Foundry to lower costs and improve energy efficiency for their wafer designs. While the revenue from either company will not even come close to the amount Intel would get from Apple, it keeps Intel technology out of the hands of other microprocessor designers.

Margin Notes

There’s no doubt that foundry work comes at a significantly lower gross margin than creating its own designs for Intel. CEO Paul Otellini said himself, “We don’t want to compete with Taiwan Semiconductor.” The company is simply looking for business to fill its idle capacity as it brings new products down the pipeline.

Taiwan Semiconductor’s gross margin usually falls in the 45% - 50%. That’s about what Intel can expect from its foundry business. Comparatively, Intel has brought in gross margins in excess of 60% for the last three years. For a small portion of the company, small gross margin is fine, especially if it’s using production capacity that would otherwise stand idle. However, if Intel were to take on the work of Apple and Qualcomm, it would have to dedicate a significant amount of capacity to fabrication – an endeavor seemingly less worthwhile. Instead, the company may be better off limiting its capital expenditures, focusing on R&D, and boosting its margins.

No Sudden Movements

If Intel Foundry Services continues down the path it’s on, I believe that it can be a nice bonus for investors as the company capitalizes on its excess production capacity and leading-edge technology. However, I think a deal with Apple could have mixed results for the company. It would certainly split the company’s focus between increasing fabrication capacity and creating leading chip designs, and likely have a negative impact on profit margins. Yet, it would give the company a foot in the door to the mobile computing industry. If Intel and Apple do team up, investors will have to examine the costs and benefits of the business deal the companies work out.

Working with a company like Xilinx, however, would be great for Intel. The company likely won't have to spend extra money on capital expenditures, it won't have to fabricate its competitor's designs, and it will keep its facilities busy while it brings new products down the pipeline. As I believe a Xilinx deal to be much more likely than an Apple deal, and therefore like the direction Intel is headed with its foundry business.

adamlevy has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple and Intel. Motley Fool newsletter services recommend Apple and Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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