Intel Faces a Challenging 2023 as Demand Weakens and Competition Intensifies

Sector Director

Brian Colello

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Intel remains the market share leader in the integrated design and manufacturing of microprocessors found in PCs and servers. Historically, the firm supplied the most powerful CPUs, though it has several manufacturing missteps in recent years that has caused the company to lose market share. We think the company will eventually catch up with its rival Taiwan Semi (TSMC) for advanced manufacturing, but the turnaround will take some more time and we anticipate further share loss and downbeat financial results out of Intel for the next year or two.

Intel historically differentiated itself via the execution of Moore's law, which predicts transistor density on integrated circuits will double about every two years, meaning subsequent chips have substantial power, cost, and size improvements. This scaling advantage was perpetuated through higher-than-peer-average R&D and capital expenditure budget that allows it to control the entire design and manufacturing process in an industry where most competitors focus on only one phase. However, the firm was unable to effectively maintain Moore’s Law with recent processes. TSMC, the world’s leading foundry, jumped ahead, and Intel’s chief design rival, AMD, has leveraged TSMC’s strength to build industry-leading x86 CPUs and encroach on Intel’s formerly dominant x86 position.

As cloud computing continues to garner significant investment, Intel's data center group has been an indirect beneficiary. Mobile devices are the preferred device to perform computing tasks and access data via cloud infrastructures that require large-scale server buildouts. This development has provided strong tailwinds for Intel's lucrative server processor business over the past decade. However, given manufacturing issues, we believe Intel will lose market share in the data center in the coming years due to intense competition from AMD and customers designing their own ARM-based CPUs.

The rise of artificial intelligence has also unleashed a new competitor in Nvidia for specialized chips to accelerate AI-related workloads. Consequently, Intel is now pursuing an array of non-CPU endeavors, including a discrete GPU for AI and other data center workloads.

Business Strategy & Outlook

We assign Intel with a narrow moat rating. This rating is lower than our former wide moat rating for Intel, as we are no longer certain that the firm can generate excess returns on capital over the next few years. 

We still believe Intel possesses cost advantages realized in the design and manufacturing of its cutting-edge microprocessors and intangible assets related to its x86 instruction set architecture license and chip design expertise. However, we believe Intel's cost advantage has eroded, as it faced significant product delays associated with its various process technologies. Intel's x86 rival, AMD, and its foundry partner, Taiwan Semiconductor Manufacturing, or TSMC, have combined to leapfrog Intel in cutting-edge processors. In turn, in recent years, Intel has lost market share, conceded on pricing, and faced a sharp decline in gross margins and returns on invested capital. We believe that it is more likely than not that Intel can close the gap with TSMC/AMD and generate excess returns on capital over the next decade, but this is no longer a certainty, and we concede that Intel's manufacturing inferiority to TSMC/AMD will persist for the next year or two and perhaps longer.

Intel primarily designs and manufactures central processing units, or CPUs, for PC and data center end markets. We believe Intel’s narrow moat is predominant in these business lines. Intel’s cost advantage is manifested via large scale semiconductor fabrication facilities that cost $20 billion-plus and create significant barriers to entry. Intel’s only competition for leading-edge semiconductor manufacturing is TSMC and Samsung. Semiconductor manufacturing is inherently capital-intensive and thus requires methodical planning and execution to keep the cost per chip at a reasonable level. Intel accomplishes this through investments in the latest process technologies.

Following along the pathway prescribed by Moore's law, coined by one of Intel's chief founders Gordon Moore, the number of transistors per unit area doubles approximately every two years. As process technologies develop, the cost per unit area increases while the unit area per transistor decreases. Thus, by netting these two trends, Intel is able to decrease the cost per transistor with each successive technology node. Intel has pioneered key innovations such as fin field-effect, or FinFET, transistors (3D transistors) at its 22 nm process that allowed superior power, performance, and (smaller) area (whereas TSMC and Samsung didn’t implement FinFET until their 16 and 14 nm processes, respectively).

However, for the economics of the business to be pragmatic, there needs to be strong demand via differentiated products that can be sold at high margins and sufficient volumes. Over the years, Intel has managed to maintain high prices for its leading-edge processors in the PC and data center markets. In turn, the company can reinvest in state-of-the-art fabs and a massive research and development budget, in order to innovate on the next generation of best-in-breed processors. Intel remains the vast market leader in x86 PC and server CPUs (80%-plus market share in aggregate, per Mercury Research) and this virtuous cycle has served Intel well over the past few decades.

In addition, Intel also boasts intangible assets related to its x86 license and chip design and process technology expertise. The x86 ecosystem (in which both Intel and AMD’s core products coexist), is representative in the vast majority of PC and server CPUs. Intel initially developed x86 in 1978 and licensed the architecture to AMD, in order to satisfy conditions from IBM that required a second source of chips. Intel and AMD are the primary licensees of x86 and owners of x86 intellectual property, as they have a cross-licensing agreement that covers the x86 patent portfolio and would be terminated if either firm was acquired or had a change of control. Effectively all computer software written to run on PCs and servers is written specifically for the x86 architecture, which makes it challenging for non-x86 chipmakers (such as those that license ARM architecture, such as Qualcomm, Broadcom, or others) to encroach upon Intel and AMD’s x86 CPU turf. In turn, both Intel and AMD have been able to maintain high pricing on its x86 processors and fend off any ARM-based upstarts.

In CPUs, we believe that high customer switching costs are pervasive within the x86 ecosystem, as a wide variety of software is written to be optimized on x86 processors from Intel and AMD. These switching costs have likely kept ARM-based processor suppliers at bay over the years. However, we do not attribute switching costs as a moat source to Intel because its PC and server CPU customers can switch somewhat easily between Intel and AMD CPUs. In fact, Intel may benefit from some modest switching costs over AMD in the data center, most notably around the software and support provided to server customers. The life cycle of such devices is also rather short, meaning a design win into a given PC or server model does not guarantee decades of repeat business.

We believe that Intel still benefits from both a cost advantage and intangible assets around x86, although we acknowledge that the business is under assault from a variety of angles, all of which have led us to reduce our moat rating for Intel to narrow from wide. The biggest concern of ours in recent years has been Intel's manufacturing delays with its 10-nanometer process. The company's ineffectiveness in delivering these processors to market has "broken" the firm's former virtuous cycle and its “tick-tock” strategy, in which the firm advanced it technology node every two years to reduce feature sizes (the tick), while it launched a new architecture for its microprocessors during the years in between (the tock). In turn, TSMC and AMD have taken the technological lead in x86 products.

Intel has been steadily losing market share in PC and server CPU markets to AMD as well as ARM-based CPUs. We also believe Intel has conceded on price, to prevent this share loss from becoming even worse. Similarly, Intel’s GAAP gross margins have deteriorated rather significantly.

We believe that 2023 will be challenging from both a technological and financial perspective for Intel, as we think TSMC and AMD will remain on the manufacturing forefront. We think it is probable that Intel will make up some ground with its Intel 4 process node, thanks to the insertion of EUV lithography that will greatly simplify its manufacturing process. We also expect Intel to utilize TSMC for some "chiplets," or chip parts, to ensure Intel can meet its milestones for product releases. The next major transistor innovation expected to succeed FinFET is gate all-around, or GAA, that will allow chipmakers to continue traversing Moore’s Law. TSMC and Samsung are expected to deploy GAA in future processes (3 nm and below), and we believe Intel has an opportunity to be more competitive if it can better deploy GAA.

We don't necessarily believe these moves will allow Intel to leapfrog TSMC/AMD, but they should bring Intel much closer to its rivals. Even if Intel is further delayed and continues to lag TSMC for an even longer period than we anticipate, we still foresee Intel having a manufacturing advantage over nearly every other chipmaker. Additionally, we think customers will continue to source products from Intel (either directly or via its foundry efforts), primarily to avoid concentration risk with TSMC.

Outside of x86 chip manufacturing, Intel and the x86 ecosystem faces the risk of displacement from ARM-based processors. ARM-based chips (the primary competition for x86-based chips) have proliferated mobile computing, including nearly every smartphone and tablet, but have had very little success in displacing x86 in PCs and server (until very recently) due to the costs of rewriting software and lack of sufficient performance. We expect ARM-based chips to generate some traction in the coming years. Apple's shift has been most notable, as it has deployed its own ARM-based CPUs, the M1 and M2, within its Mac computers. Amazon, Microsoft, Nvidia, AMD, and a host of others are focused on ARM-based processors, too. However, we think this transition will be slow. 

One critical area dominated by x86 is gaming, with both PC gaming and premium video game consoles heavily centered on x86-based processors. Usually, x86-based platforms have more powerful CPUs and GPUs with many compute cores and memory, which are important factors when trying to maximize performance (including framerate and graphical fidelity). While the broader PC market has plateaued over the past decade (before a COVID-19-related resurgence in 2020 and 2021), the PC gaming sub-segment remains a robust market that we expect will remain x86-centric as we’re skeptical the majority of high-end PC games will be rewritten for ARM-based computers any time soon.

In servers, several leading hyperscale cloud customers have been interested in ARM-based CPUs for years, with Amazon notably designing its own ARM-based Graviton processors. However, we believe these ARM-based chips will remain limited to relatively less-intensive workloads, and we do not foresee Amazon or its peers such as Microsoft or Google converting 100% of its data center workloads to ARM-based processors. While switching from x86 to ARM is not impossible and does happen, we believe the bar that needs to be cleared is higher: the chip needs to be faster, more efficient, cheaper, and have the support to port over. Rewriting software to run on a different architecture is a considerable hurdle that we think will stifle ARM inertia in the coming years.

Outside of x86 PC and server processors, we like Intel's efforts to diversify its business via organic and inorganic efforts, including the pursuit of burgeoning opportunities in the Internet of Things, AI, and automotive. Intel acquired two narrow-moat firms in recent years (Altera for FPGAs and recently spun off Mobileye for automotive computer vision processors) and AI startups such as Habana Labs, Nervana, and Movidius. Given the relatively smaller contribution to total sales, we don’t view these adjacencies as material to Intel’s narrow moat rating at this juncture. That said, we anticipate Intel’s sales in AI accelerators, 5G basestation SoCs, networking, and other server chips will outpace the firm’s PC and server CPU businesses in the coming years.

Additionally, Intel plans to offer foundry services to fabless chip designers. Amazon, Qualcomm, and MediaTek have already signed up as partners, and we suspect that Intel will strive to win future business from Apple, as well. We think Intel’s foundry business will require at least a few years to build the credibility required for high-volume orders, but we ultimately expect Intel to emerge as a decent rival to TSMC and Samsung in the foundry industry.

With regard to the CHIPS and Science Act signed into law in August 2022, we expect Intel to enjoy some subsidies, as part of the funds from the legislation (about $39 billion) will be available for the construction and expansion of chipmaking facilities. These funds should help Intel fund its increasing capital expenditure plans for its internal and foundry manufacturing efforts, in turn boosting ROICs. However, we do not consider government subsidies as part of our moat rating.

Narrow

Economic Moat

Intel

Intel Corp. engages in the design, manufacture, and sale of computer products and technologies. It delivers computer, networking, data storage, and communications platforms. The firm operates through the following segments: Client Computing Group (CCG), Data Center Group (DCG), Internet of Things Group (IOTG), Non-Volatile Memory Solutions Group (NSG), Programmable Solutions (PSG), and All Other. The CCG segment consists of platforms designed for notebooks, 2-in-1 systems, desktops, tablets, phones, wireless and wired connectivity products, and mobile communication components. The DCG segment includes workload-optimized platforms and related products designed for enterprise, cloud, and communication infrastructure market. The IOTG segment offers compute solutions for targeted verticals and embedded applications for the retail, manufacturing, health care, energy, automotive, and government market segments. The NSG segment is composed of NAND flash memory products primarily used in solid-state drives. The PSG segment contains programmable semiconductors and related products for a broad range of markets, including communications, data center, industrial, military, and automotive. The All Other segment consists of results from other non-reportable segments and corporate-related charges. The company was founded by Robert Norton Noyce and Gordon Earle Moore on July 18, 1968, and is headquartered in Santa Clara, CA.

Earnings data Q2 2023

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Intel Corp. engages in the design, manufacture, and sale of computer products and technologies. It delivers computer, networking, data storage, and communications platforms. The firm operates through the following segments: Client Computing Group (CCG), Data Center and AI (DCAI), Network and Edge (NEX), Mobileye, Accelerated Computing Systems and Graphics (AXG), Intel Foundry Services (IFS), and All Other. The CCG segment consists of platforms designed for notebooks, 2-in-1 systems, desktops, tablets, phones, wireless and wired connectivity products, and mobile communication components. The DCAI segment delivers solutions to cloud service providers and enterprise customers, along with silicon devices for communications service providers and high-performance computing customers. The NEX segment offers computing system solutions from inflexible fixed-function hardware to general-purpose compute, acceleration, and networking devices running cloud native software on programmable hardware. The Mobileye segment develops driving assistance and self-driving solutions. The AXG segment provides products and technologies designed to help customers solve the toughest computational problems. Its products include CPUs for high-performance computing and GPUs targeted for a range of workloads and platforms, from gaming and content creation on client devices to delivering media and gaming in the cloud, and the most demanding high-performance computing and AI workloads on supercomputers. The IFS segment refers to full stack solutions created from the foundry industry ecosystem. The All Other segment represents results from other non-reportable segments and corporate-related charges. The company was founded by Robert Norton Noyce and Gordon Earle Moore on July 18, 1968, and is headquartered in Santa Clara, CA.

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