Intel's Datacenter Problems

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

This earnings season hasn’t been the hottest for the technology sector. Google missed expectations, Microsoft fell flat on its face, and Intel (NASDAQ: INTC) just barely met expectations (that were already lowered).

Chipzilla's problems

Okay, I’ll admit it; I haven’t been a huge fan of Intel. The company is too far upstream to be able to easily adjust its operations. It’s not software, it is hardware, and with hardware come a ton of fixed costs. Intel has a really small set of tools to work with.

Intel continues to struggle, as the company reported revenue that declined 5.11% year-over-year. The decline in year-over-year revenue came from weaknesses across all of its segments. The company reported that consumer PCs were down 7.5% year-over-year, with data centers flat year-over-year, and Intel architecture group (mobile division) down 15% year-over-year.

The weakness in its high-margin PC and server business was what sank revenue the past quarter. The company doesn’t seem to have a specifically defined growth strategy, which is something I have repeatedly pointed out.

The company’s cost of sales (basically cost of goods sold) was up year-over-year by 8%. Research and development and marketing costs were essentially flat. The loss of revenue, paired with the rising cost of sales, resulted in a 30% year-over-year decline in net income.

The company reported $0.39 in diluted earnings per share for the quarter. Analysts were anticipating the company to report $0.39 for the quarter. So, the company didn’t really miss its previous guidance, but at the same time, the overall direction of the business didn't improve.

The revenue guidance for the full-year was the real kicker. It went from low single digits to flat. This means that the company projects that the mobility segment will not be enough to offset the losses in its PC and mainframe business. The mainframe business is a huge concern weighing on analysts because it was Intel’s last pillar of growth, and it has finally crumpled.

IBM -- Long live the server

The mainframe business is on the decline. This is because virtualization and storage-as-a-service better utilize hardware. Companies want to outsource IT (Information technology), to third parties like International Business Machines (NYSE: IBM), Amazon, Oracle, VMware, and Cisco.

In an era of cloud virtualization, excess capacities that used to exist no longer exist. Most of the time, when a company individually builds out its own data-center, there was a lot of power left over for other uses.

But with virtualization, excess capacity is reduced. When a company offers to house your data, it houses the data on a server that may serve hundreds if not thousands of clients from the same data center. The better utilization of hardware, or the centralization of it, reduces the demand for individual servers and components.

IBM earnings 

IBM reported a 3.3% year-over-year decline in revenue for the second quarter. The decline in revenue was primarily driven by declines in the systems and technology segment which declined 11.8% on a year-over-year basis. The decline in the systems and technology segment was offset by the software segment, which was up 4.1% year-over-year.

IBM’s total expenses were up 12.2% year-over-year. The increase in expenses paired with decline in revenue resulted in the company generating $3.2 billion in net income (year-over-year decline of 16.1%).

IBM reported earnings per share of $3.91 per share. The company beat the consensus earnings estimate of $3.77 per share for the quarter. The stock is 5.52% above its 52-week low.

Back to Intel

Some could argue that Intel could create better products, or different product categories, but most of those opportunities have been exhausted by Intel.

Companies that offer infrastructure-as-a-service (outsourcing of servers), and platform-as-a- service (servers, and tools for web based programs), are decreasing the usage of hardware components. A cloud data center may have hundreds if not thousands of customers, this means that pre-existing hardware is being used more efficiently, as a result, IT spending may continue to fall.

Another concern is that larger hard drive capacity and faster computing will lower the total number of servers needed to manage the large pools of data that humans are currently using and creating. Because of competition, Intel has to release faster processors even if it lowers the total demand. Also, Intel cannot freely raise prices without risking market share losses to competitors like Advanced Micro Devices and NVIDIA.

Another dilemma that Intel currently faces is that Intel has stolen so much market share from AMD, that there's not much left to steal (AMD has around 20% of the consumer x86 market, but mostly in the low-end). Intel always beats AMD at making processors, and I believe this will continue. The benefits from taking market share from AMD are diminishing as computer shipments have declined for five quarters in a row. I don't think Intel can offset the difficulties in the computer environment by stealing market share away from AMD and NVIDIA.

The demand for mobile Intel processors won't increase as much because Qualcomm dominates both the low and high-end. Qualcomm can price its chips for a lower price and still earn a profit (due to greater economies of scale).

At this point, Intel should look to anything outside of hardware to sustain growth.

Conclusion

Don’t get your hopes up, Intel fans. The server and consumer business on the semiconductor side is dead. PCs could be due for a bounce in 2014 due to a Windows XP refresh cycle, but with Intel so heavily exposed to PCs and servers, I honestly can’t recommend investing in the company.

IBM, on the other hand, did fairly well this past quarter. What’s saving the company is its openness to change, and the willingness to sell services, software, and support. The demand for servers will go up, but the way the market is structured, it seems that hardware is dead and service remains king.

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Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel and International Business Machines.. 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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