By Jon Fortt
March 6, 2008

Memory prices are bruising profit margins, but CEO Paul Otellini says the chip giant can still thrive.

Facing flagging profit margins and a skeptical Wall Street, Intel

CEO Paul Otellini hosted investors at the company’s Silicon Valley headquarters Wednesday. His message: Despite a weak U.S. economy and an ugly memory market, the Internet boom will supercharge revenues at the world’s largest chipmaker.

“We essentially think we can triple the market for our products,” Otellini told a gathering of financial analysts. “And this isn’t assuming that we have a full run of every market; it’s assuming we have a moderate view of success.”

But Intel’s growth story is a tougher sell today than it was a few months ago, which helps explain why the company took the unusual step of hosting investors at its Santa Clara headquarters instead of doing the event in New York as usual. And the tough sell is not just an issue for Intel; since November, when it became clear that the U.S. subprime mortgage crisis could tip the economy into recession, the tech industry in general has been hit hard. Stocks like Intel and Apple

that were investor darlings in 2007 have suffered gut-wrenching losses; Intel has shed more than $35 billion in market capitalization, a quarter of its value, since December.

Making matters worse, Intel was forced this week to warn investors that its profit margins would come in lower than expected because of free-falling prices for NAND flash memory, the type of storage used in trendy devices like the iPod and iPhone. In the last quarter of 2007, Intel’s profit margins took a hit when memory prices dropped 28 percent, a trend the company knew would continue in 2008.

But things have deteriorated even more rapidly since the end of 2007. Otellini said that this quarter flash memory prices have dropped another 53 percent. The memory fire sale has not only meant Intel makes less from the flash memory it sells, but it has also left Intel holding a backlog of product that’s worth far less than the company imagined.

The resulting pain on the balance sheet seems to have rattled Otellini’s willingness to place big bets on the volatile memory market. He said that in the second half of 2008 Intel will try to aggressively sell flash-based storage drives to laptop manufacturers, hoping to ride the popularity of thin machines like Lenovo’s X300 and Apple’s MacBook Air. But taking a cautious tone, he also made it clear that Intel is taking a more tentative approach to growth in a business that might be less profitable than expected — and that if things get much worse, Intel might abandon the memory business completely.

“I want to give you my personal commitment that this business will not be a drag on Intel Corporation,” Otellini said. “We’re going to fix it, or we’re going to make sure that it’s profitable, one way or another. This is a business that we entered on the assumption of profitability, and we intend for it not to drag down the company.”

The memory mess has damaged more at Intel than profit margins — it has caused Intel to stumble in what should be its victory lap. Coming out of a rough 2006, Otellini had spent a year rebuilding trust with Wall Street by cutting costs and painstakingly building a case that under his leadership, Intel had the discipline to retake ground it lost to rival Advanced Micro Devices (AMD). Those efforts largely paid off; Intel outplayed AMD in 2007, and the stock rebounded from lows in the teens to a high of about $28 per share.

But a slow economy and Intel’s memory-based profit headaches have combined to foul Otellini’s profit targets and send the stock skidding again.

Memory headaches aside, Otellini and other executives tried to paint a picture of a company poised to benefit from the ongoing revolution in online content. Video will be the driving force in advertising and Internet entertainment they said, and consumers worldwide will need new Intel-based laptops to watch it on the go. The demand for online services will create a market for efficient new Intel-based servers in power-guzzling data centers. Cell phone makers will eventually adopt Intel chips because it’s easier to write software for them. And WiMax, the Intel-backed high-speed wireless data technology, will spark even more innovation in the developing world.

And those observations are more than a pipe dream. The global market for PCs has remained stronger than analysts had expected, providing Intel with strong revenues and profits. Meanwhile Intel’s powerful manufacturing advantage has allowed it to bring smaller, more efficient chips to market more quickly than its rivals, helping the company add more than $1.5 billion in cash last quarter (though it seems likely that the memory issue will hurt Intel’s cash flow for the next two quarters).

On a sunny day in Silicon Valley, investors were probably more open to Intel’s upbeat message than they would have been in blustery New York. It was clear, though, that Otellini and his team were asking them to take another leap of faith — and faith in tech companies is in short supply this year.

Bottom line? Frustrating though it might be for Otellini, after he spent 2007 proving Intel’s mettle, he’ll have to do it again in 2008.

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