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All Risk and No Reward


Thx Fleck!


Note: Professor Fleckenstein provides his commentary for educational purposes - his insights are not intended as investment advice. You can find his daily comments at

Please also note that this is Prof. Fleckenstein's Rap that was published yesterday afternoon, however given Fleck's focus / expertise in the area, we still find it helpful.

Early Reveling in Intel

Overnight markets were mixed, but our equity futures were higher on the back of Intel's earnings release. It was a triumph of obfuscation (followed by speculation) over fact, and I'll have a lot more to say about that below. The early going saw the Sox up 3%, as chip-blip dip buyers were out in force after bad news once again was unable to dent stock prices, and therefore, the speculative beta-chasing community was eagerly piling in. That produced a bounce of about 0.5% in the Nasdaq. Internuts were also being chased with reckless abandon, due to Yahoo's report.

Interestingly, the S&P and the Dow were red, even as the recent catalyst du jour, oil, was similarly red in the early going, to the tune of 1.5%. Housing stocks and cyclicals were also laboring, with the latter pressured by an absolute slaughtering in base metals. Just to pick a couple of examples, copper was down 10% and zinc down about 15% in the early going.

Woe in Wood-Chip Land

The early-morning ramp job in tech basically petered out all day, though it didn't totally collapse, as one can see by the fact that the Sox closed up a couple percent. Nevertheless, the major indices were red, and the Dow was back again hovering around the 10,000 level. The homeboys really took it on the chin today, down another 3% to 4%, as stories continue to circulate about housing inventory being up in many locations.

Cyclicals were clubbed as well, which is not shocking, given what happened to base metals. That said, the price changes were pretty shocking, as Phelps Dodge was down about 10%, to cite but one example. All in all, it was a bit of a schizophrenic day. Folks tried to be brave bad-news-buyers in chip land, but elsewhere, skittish sellers prevailed.

Oil Retools to the Upside

Away from stocks, precious metals were under considerable pressure in the early going, with silver down better than 3% and gold down just about 2%. After the early drubbing, they saw a big bounce and cut their losses, closing down 2% and 0.5%, respectively. Late in its trading day, oil staged a dramatic turnaround: It rallied from negative on the day to up about 2% on the day, finishing almost on a new closing high for the move at $53.64.

Also late in its trading day, the euro reversed earlier losses, to close up on the day. And, I might add that the rally in the euro boosted the metals in electronic trading after they'd closed, such that gold's losses on the day were completely eradicated, and silver's nearly were, too (at least as of 4 p.m. Eastern time, when the Rap was put to bed). Fixed income was up fractionally and appeared unmoved by all action elsewhere.

INTC University

Now for a discussion of Intel. Regular readers know that I have spent a lot of time delving into the company, which I have done for a variety of reasons. Number one: Off and on over the years, Intel has been a very profitable short position for me, so I am quite focused on it. Number two (and more importantly for everyone besides moi), I think there are many lessons to take away from how Intel has behaved.

I have long said that Intel, along with IBM (and of course many others), are classic examples of mismanaging your business in the long run to maximize your stock options in the short run. In my opinion, many tech companies are not in whatever business they claim to be in. They're really in the business of producing a rising stock price -- with the underlying business merely a sidelight whose "metrics" are used to drive the stock price.

"Metrics" was a particularly popular theme (and one of my pet peeves) in the original mania, and especially embraced by Internet companies, which of course had no fundamentals, so they had to resort to metrics. But that's a whole other issue.

Stock Options: Keep Back 200 Feet

As circumstantial evidence to try to prove my case that it's all about stock options, please note that Intel crowed that they used $2.5 billion to buy another 106 million shares. And of course, they have led the disingenuous fight about the impossibility of calculating what options are really worth. I find it more than slightly ironic that this maker of the engine of the machine on which you are reading what I am saying claims not to be able to value stock options. And, as you will see in a minute, Intel claims not to be able to add up a handful of different items included in their inventory charges last night.

Specifically, Intel's fundamental problem is that they've tried to spend their way through a downturn that's really not a downturn but a saturation problem. Folks don't need more PCs, and they don't need faster processors. Yet, Intel needs, above all else, to charge a high price for their product, which of course is not exactly a good way to stimulate demand in a market that's saturated. Meanwhile, as Intel has tried to spend their way out of capacity -- and spent gobs of time cheerleading/defending their stock price -- AMD has produced a superior mousetrap, as I've discussed many times in the past, and is now busily taking market share.

To summarize: Intel's fundamental problem is that they have put up too much capacity and are creating more product every day, week, month, quarter, etc., than they can sell. In fact, you will see that if Intel were to bring capacity in line with demand, they would likely make no money.

What's Writ in the Write-Down?

Now let's turn to what happened last night: Most people expected Intel's inventories to go up, as did I. There was a cry of relief amongst the bullish contingent that inventories actually dropped $43 million on a base of $3.2 billion. However, Intel took an inventory write-down and a reserve for inventory. Inexplicably, they would not divulge the total amount of those adjustments. Though pestered about this a couple times on the call, they absolutely refused to give a number and used a whole bunch of weasel words about why:

Question: "Could you please give some quantification of what the reserve was in dollars in Q3." Answer: "I [Andy Bryant] won't answer your question specifically. I'll try to give you a little better feel." Then Bryant goes on to spew a whole bunch of nonsense, such that the questioner comes back with the following: "You lost me with the reserve." Answer: "There are three buckets of reserves. Some are okay reserves, some are bad reserves . . . [he never mentioned the third reserve]." Question: "So what was the magnitude of the reserve?" Answer: "I didn't give you the specific."

Then, near the end of the conference call, the question came up again: "Can't we just get an overall inventory-hit number out of you guys? Answer: "Not this time. If it were one big item, I would. But . . . I've got a series of five to seven, eight to 22 million-dollar things. So it's very difficult to cull them out, because there's not a single thing that's important enough to be culled out." Of course, what the questioner wanted to know was the total magnitude of the inventory adjustments, but Andy Bryant went into his comments about the specifics so as not to answer the question. Bottom line: He refused to tell everyone how big of an adjustment Intel took this quarter.

Inventory, The Envelope, Please

However, it is possible to deduce approximately what the size of that charge was, and here, I am indebted to my friend Fred Hickey, who knows more about all these tech companies than do the guys who run them. He pointed out that for at least the last four quarters, Intel's cost-of-goods-sold has ranged from about $3.185 billion to $3.275 billion. In other words, $3.2 billion has been a good running average for their cost-of-goods-sold.

I need to make an oversimplified point here: Intel has a high-fixed-cost business. They put sand in the front end, and out come high-margin chips on the back end. The cost of doing business stays pretty much the same, pretty much no matter what their volumes are. Their margins move up and down with their revenues. It's an important point to understand.

In any case, last night we saw that their cost-of-goods-sold jumped to $3.752 billion, which was up $483 million from the prior quarter. Some of that increase may be a legitimate uptick in cost-of-goods-sold. However, the majority of that number is likely to be the approximate size of the inventory adjustment, both write-off and reserve, that Intel took. This is roughly greater than 10 times the size of the decline in inventories. Even though without a breakdown between the size of the write-off and the reserve we can't know for certain what happened, it would be almost impossible for the units that they have in inventory not to have risen.

And, if you go back and look at the last time Intel had to finally start biting the bullet on an inventory problem (in the third quarter of 2001), you will see that their cost-of-goods-sold popped up to about $3.6 billion. But back then, their inventory declined from $2.8 billion to $2.35 billion, i.e., a drop of about 450 million, as that inventory got flushed through the cost-of-goods-sold. Currently, inventory is still $3.2 billion.

Waxing Poetic on Wee Whittling

Though CFO Andy Bryant was completely and totally evasive on the call about the size of this write-off, he did crow that they were making progress in whittling down their inventory. Well, given the size of their inventory and whittling it down $40 million a quarter, you can quickly see that it would take about 80 quarters or 20 years to get rid of it all. That's of course an extreme way to look at it, and it obviously wouldn't take that long. But the point survives that the "progress" they made is pathetic, especially given the size of the adjustments they didn't want to disclose.
So, where does that leave Intel, and why does all this matter so much? As I started out by saying, their fundamental problem is that they have too much capacity. How much, we can't say for sure, but we can try to make a stab at it. In the last four quarters, they have built up nearly one-quarter's worth of inventory. Again, even though the inventory on the books is only $3.2 billion, since their gross margins are 50%-plus, it works out to be about $7 billion worth of inventory, or roughly a quarter's worth of revenues. (Once again, I am oversimplifying this, because not all of Intel's inventory is processors. But for the purpose of illuminating the example so that everyone can follow it, I have to make some broad assumptions.)

No Pent-Up Demand 4 Pentium 4

In any case, Intel now has a quarter's worth of revenues in inventory, up $1 billion, or 50%, over the last five quarters. Well, what would their profits look like if they cut their output by, say, 25% to bring supply and demand in line? Virtually nothing would happen to their expenses. But 25%, or about $2 billion, would be cut from their revenues, which would simultaneously shrink profit by $2 billion, as well. Given that Intel's pretax operating profit is only $2.3 billion, you can quickly see how fast their earnings would evaporate, and that's why they're so reluctant to cut capacity.

High-fixed-cost businesses are wonderful once you can produce above the break-even level, because the revenues from the incremental products all fall to the bottom line. But leverage cuts both ways, and profitability can reverse rather quickly.

Intel would face a similar problem if they decided to try to cut price rather than capacity. Obviously, their cost-of-goods-sold wouldn't change much, but their revenues would shrink, and they'd have the same problem I just went through. In order for them to move their inventory, they are going to have the problem of trampling prices in the market. If they were forced to try to sell all of their extra quarter's worth of inventory on the books in one quarter (which they wouldn't), your guess is as good as mine as to what price they might receive in an attempt to sell everything.

If they were able to sell it at, say, 60 cents on the dollar, then their income statement would look something like this: $3.2 billion for the cost-of-goods-sold for what was made this quarter. $3.2 billion for the cost-of-goods-sold for what was in inventory. That's about $6.4 billion for the cost-of-goods-sold. The $7-$8 billion of revenues that the inventory grossed up to, plus a similar amount that the quarter they were in grossed up to, equals $14-$15 billion. The latter multiplied times 0.6 is $8.4-$9 billion, less the combined cost-of-goods-sold of $6.4 billion, plus their operating expenses of $2.3 billion, once again leads to almost no profit margin. (Again, I am being overly simplistic to illustrate the point.)

Hiding in Plain Sight

What I find staggering is that Intel thinks they can get away with this stonewalling, even though the problem is hiding in plain sight. They've engineered themselves into a giant predicament, but Intel is not alone in this. Many companies in chip land (and their predicament obviously affects the chip-equipment companies), as well as other industries, have built up too much capacity. However, due to their reluctance to admit to that, they resort to all kinds of games. In the long term, this inability to face up to their mistakes will only put them into a worse position.

Hopefully, the foregoing discussion makes it clear why you would not want to pay 4.2 times sales, now that Intel's revenues have been stagnant for over four years, compared to the approximately 2 times sales it traded for from 1988 to 1994, when it was still growing rapidly and had the bulk of the PC boom still in front of it. Intel today is a textbook example of all risk and no reward.

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