Intel’s Second Quarter Earnings—A real “Green Shoot”

Morris Segall      2009 economy, business landscape, earnings report, economic, economic recovery, economics, GE, Intel, trends

In our July 5th blog entry, “June Employment Report–Green Shoots Fading“, we commented that a doubtful economic recovery expected in the third quarter and pessimistic earnings guidance from companies reporting second quarter earnings this month would in our opinion herald stock market corrections here and abroad near term. Since that posting the Dow Jones Industrial Average declined approximately 5% in the ensuing five trading sessions before rebounding on expectations of robust bank earnings to be reported this week. Indeed, Goldman Sachs reported a “blowout” quarter led by its investment banking activities. However the more significant earning news yesterday came from Intel that reported a surprisingly strong second quarter highlighted by a surge in revenues and unexpected expansion in gross margins from increased unit volumes of consumer products. Even more importantly, the company reestablished earnings guidance for the remainder of the current fiscal year as the outlook for its business became more visible and positive. This is the kind of earnings encouragement that is necessary to sustain the market recovery begun last March. To be sure, Intel’s business turn may be truly singular to itself and not indicative of a broader upturn in the technology sector but as a bellwhether in the industry and in the major market averages, the substantial improvement in Intel’s performance and outlook lead us to believe we are at or near the bottom of the earnings cycle for non-financial companies. Indeed, we feel Intel’s results signal the same kind of shift in corporate earnings we saw at the opposite end of the spectrum in early 2008 when we wrote our article, “GE, the Earnings Cycle and Food”, April 14, 2008. In that article, we noted the deterioration in GE’s first quarter 2008 earnings and the very negative implications for the rest of S & P 500 corporate earnings last year.

The Intel results reflect successful new product introductions, stringent cost control, inventory reduction and strong sales. The strong sales reflect strong demand for PC products from China and the U.S. aided in the latter by bargain selling prices by the company’s resellers and buying stimulus from accelerated write-offs offered by the Federal government. The higher sales volume and cost reductions allowed the company to record much expanded gross margins in the quarter despite lower average selling prices and lower unit margins on consumer products. This has been a theme of ours supporting a positive outlook for common stocks led higher by rapidly increasing corporate profits from increased gross margins from increased unit sales volume.

The new, improved visibility for increased unit sales, continued cost controls and tight inventory control is allowing the company to forecast improved gross margins for both the third and fourth quarters of the current fiscal year which may force analyst earnings forecasts to be raised. This is also reinforcing another of our themes for the recovery cycle, namely the pent up demand for computers that can only be deferred for so long before a new sales cycle begins. Currently, the new demand is coming in consumer products but the company expects business demand to pick up next year for the same reasons. Importantly, the higher end business products carry higher unit margins which should amplify Intel’s earnings when the economy recovers.

Thus, we are encouraged that the Intel earnings report contains the seeds of a bottoming in earnings in the technology sector and possibly other areas of Producers Durable Equipment sector, i.e. capital goods as pent up demand, bargain purchase prices, accelerated equipment write-offs and fast return on investment and increased productivity lead to a recovery in this sector. We expected this sector to be a leading element in the economic recovery forecasted for next year due to short lead times for purchase and profitable returns. The Intel earnings report and new guidance give us reason to believe in that forecast. And yet we still believe in our comments of July 5th that many companies will not have the positive guidance outlooks of Intel, i.e. consumer discretionary, real estate, transportation to name a few. In view of this and the continued weak near term economic environment, we still believe the capital markets are vulnerable near term to the downside as economic and corporate earnings remain weak. Neverthless, our intermediate and longer term outlooks are reinforced by the Intel results.

Morris R. Segall, CFA, CIC