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(Image courtesy of Intel).

Intel's Sales Jump in Second Quarter as Tariff Threat Looms

Intel reported strong sales in the second quarter bolstered by robust demand for chips used in personal computers and Internet of Things devices. Customers also stepped up purchases of its higher performance server products, which propped up the Santa Clara, California-based company's profit margins. Sales in the second quarter were almost $1 billion above the company's forecast in April.

Sales for the world's largest chip manufacturer fell 3% to $16.5 billion, crushing its $15.6 billion forecast from the end of the first quarter. The strong financial results eased concerns about a slowdown in global semiconductor sales and the uncertainty surrounding the bitter trade battle between Washington and Beijing. Net income, however, fell to $4.2 billion, or $0.92 per share, from $5 billion, or $1.05 per share, a year ago.

Customers concerned about Washington and Beijing imposing new tariffs on each other in the second half of the year are building up inventory as an insurance policy. Bob Swan, Intel's chief executive, said the threat of new tariffs bolstered sales by about $400 million in the second quarter. Intel has also resumed shipping some products that it determined are not subject to the supply restrictions slapped on Huawei in May. 

Intel has weathered the trade war so far without any serious financial damage. The Silicon Valley company shared a strong forecast with projected profits of $1.24 a share in the current quarter—an increase of 35% versus the second quarter—on sales of around $18 billion. Others have also played down the impact of the trade conflict. Texas Instruments last week said that the dispute had not affected its ability to sell in China.

"The quarter played out much stronger than we expected," Swan said on an analyst conference call last week.

The company also raised its forecast for the 2019 fiscal year by $500 million after the stronger-than-anticipated second quarter, bringing it to $69.5 billion, down from around $70.8 billion in 2018. At the end of the first quarter, Intel shaved $2.5 billion from its $71.5 billion forecast to account for flagging memory chip sales and reduced spending on cloud data centers—its fastest growing market in recent years—particularly in China.

How the trade conflict with China will play out is still shrouded in uncertainty. Swan said Intel was entering the second half of the year "a little more cautious" than it was three months ago. "There are still unknowns about how China is going to play out and since that's an important market for us, that's probably what makes me a little nervous," Swan, who stepped up from chief financial officer role in January, told analysts.

Intel is scrambling to solve more fundamental challenges to its dominance in data centers and personal computers. The company is rushing to boost its production of chips based on its 10-nanometer process, which has been severely delayed due to manufacturing glitches. TSMC has been building chips over the last year based on its 7-nanometer node, which industry analysts say is about as advanced as Intel's 10-nanometer node.

Intel said that chips produced on its 10-nanometer process will start shipping inside personal computers before the end of the year. Intel said it would start ramping up volume production of its 10-nanometer server chips in the second half of 2020. That could give rival Advanced Micro Devices a head start to sell its 7-nanometer Rome server chips, which will be manufactured by TSMC. Intel plans to introduce 7-nanometers in 2021.

Intel is also weathering shortages of its computer chips in the personal computer space, causing it to cede market share to AMD in the second quarter. Intel has struggled over the last year with a sudden surge in demand for chips powering personal computers. The shortages have forced it to focus on producing chips with higher core counts—and therefore, higher margins—while sacrificing a small share of the personal-computer space.

George Davis, the company's chief financial officer, said he expects supply and demand to balance out in the second half of the year. Intel's personal computer group boasted 1% growth with sales of $8.8 billion. Operating profit surged to $3.7 billion from $3.2 billion last year. Global PC shipments totaled 63 million units in the second quarter, up from 62 million from the same span in 2018, according to estimates by Gartner in June.

Intel’s strong growth in recent years has been propelled by its data center business, which sells server chips for thousands of dollars each. But the company has been dragged down since the second half last year by slowing sales in the data center. Server chip sales in the second quarter dropped 10% to $5 billion. Operating profit plunged from $2.7 billion to $1.8 billion as capital spending by many of its largest cloud customers cooled.

Growth in the Santa Clara, California-based company’s cloud business has slowed from 50% in the third quarter last year to 24% in the fourth quarter to 5% in the first quarter of 2019. Intel said cloud revenue slipped 1% since the second quarter last year, while sales of server chips to corporations and enterprises plunged more than 30% from a year ago. Early 5G deployments propped up communications segment sales by 3%.

Intel's Xeon server processors showed "double-digit" growth in average selling prices in the second quarter as customers shelled out for chips with higher performance. Unit shipments, however, slumped 12% in the second quarter, hampering sales significantly. Intel sees strong growth returning to the data center business in the second half of 2019 as major players in the cloud industry "digest" the inventory they amassed in early 2018.

On the other hand, Intel's Internet of Things group came out of the second quarter with sales growing 12% to almost $1 billion. Customers buying its high-performance products bumped up operating profits by 21% to nearly $300 million. Intel's Mobileye business, which sells hardware and software for advanced driver assistance systems (ADAS) in cars, reported revenues of $200 million last quarter, up 16% from a year earlier.

Gross margin was 59.8% in the second quarter, according to Intel. That compares to 61.4% from last year's second quarter and 56.6% in the first quarter of 2019. The company typically targets a gross margin—a percentage calculated by subtracting production costs from its sales—above 60%. But the company's profit margins are under pressure as its 10-nanometer chips enter volume production and AMD rolls out rival CPUs.

Intel is also selling the majority of its 5G smartphone modem business to Apple for $1 billion, pulling out of one of its most highly unprofitable businesses. Once the deal is completed by the end of the year, Apple will gain around 2,200 employees from Intel in addition to thousands of patents and other assets. As part of the deal, Intel will still be able to make modem chips for Internet of Things devices, personal computers and cars.

Selling its smartphone modem assets is part of the push by chief executive officer Robert Swan to keep spending under control and pull out of businesses struggling to make money. Davis said shutting down its smartphone modem operation would save $400 million to $500 million in 2019, up from earlier estimates of $200 million to $300 million. He said the cost savings could double to roughly $800 million to $1 billion by 2020.

"The increased savings are being offset by higher spending on 10-nanometer and 7-nanometer processes and product R&D," Davis said.

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