Restructuring Offsets Intel's Reduced Outlook

First-quarter revenue was $13.7 billion, up 7% year over year, as Intel benefited from the inclusion of Altera's financial results and continued data center growth. While the broader, embattled PC market continues to exhibit fragility, Intel's client computing group saw sales rise 2% year over year, as a 15% decline in units was offset by a 19% increase in average selling price. The firm continues to benefit from a richer client computing mix bolstered by high-end gaming and the continued rollout of its latest Skylake-based products. Revenue from the data center group was up 9% from the same period last year, with strength in the cloud offset by weakness in enterprise demand. We believe the 15% near-term data center compound annual growth rate forecast by management a few years ago will fall short for the second consecutive year in 2016, as relevant spending tends to be lumpy in nature. However, we still expect the firm to achieve data center growth in the low double digits compounded annually through 2020, on the strength of 14-nanometer-based server chips coming out in 2016 and Intel's Xeon server chips packaged with Altera's programmable logic devices that are currently sampling at customers.

Intel also broke out a new reporting structure featuring the programmable solutions group (Altera operations), nonvolatile memory solutions group (NAND flash), and Intel security group (security software products). After taking into account deferred revenue adjustments, the programmable solutions business achieved mid-single-digit growth year over year, which we surmise is due to new products. The memory group, which mostly focuses on solid-state drives sold to data center customers, was down 6%. However, management said its 3D NAND products codeveloped with Micron will begin contributing materially in the second half of 2016. Intel's conversion of its Dalian, China, fabrication facility from logic to NAND is on schedule, with the firm's 3D NAND products expected to have a cost advantage relative to competitors such as Samsung.

Gross margins for the quarter were down 500 basis points sequentially to 59.3%, mostly because of Altera acquisition-related adjustments and factory startup costs related to the 10-nanometer process node, partially offset by higher client computing ASPs. We expect similar headwinds to persist over 2016, in addition to the aforementioned Dalian fab conversion and subsequent ramp that will also curb margins in upcoming quarters. As a result, second-quarter gross margins are projected to be 57.6%.

Management forecasts second-quarter revenue of $13.5 billion, implying an average seasonal quarter after taking into account the incorporation of Altera's sales. It reduced its full-year top-line growth outlook from the mid- to high single digits to the mid-single digits, mainly due to client computing weakness and a slowdown in data center growth. We view this estimate as appropriately conservative but believe there could be additional upside tied to 3D NAND prospects in the back-half of the year.

The restructuring program is expected to result in $750 million in operating expense reduction in 2016 and annual run-rate savings of $1.4 billion by mid-2017. In the second quarter, Intel will record a one-time charge of $1.2 billion, which we think will mostly be severance-related charges for the 11% reduction in employees across the firm. We believe these moves will help Intel flexibly shift resources away from PC-related endeavors and leverage its design and manufacturing expertise in more promising fields. While there was little explicit commentary on the firm's mobile efforts, apart from continued margin improvements associated with reduced contra revenue, it appears Intel's foray into smartphone processors is quickly coming to an end, with restructuring efforts probably affecting relevant personnel. The firm is reportedly working on a modem chip rumored to be in the next iPhone, but even if this is true, we don't expect any material financial impact on Intel's results anytime soon.

Also announced was the transition of CFO Stacy Smith to a new role heading sales, manufacturing, and operations once a successor is identified. This move is consistent with recent executive turnover, including IoT head Doug Davis, client computing group vice president Kirk Skaugen, and manufacturing vice president Bill Holt. We note that some of these moves were retirement related, but we also note the connection of these departures and hiring of president Murthy Renduchintala, who joined from Qualcomm in November. While these restructuring efforts will probably take time to result in tangible results, we believe they are in line with our long-term thesis of Intel leveraging its scale and material investments in the PC market in other growth avenues such as data center, IoT, and next-generation memory solutions such as 3D XPoint. After taking into account the restructuring-related charges and cost savings, in addition to a slightly lower annual top-line growth estimate, we are maintaining our $31 fair value estimate. Near-term headwinds may create a more attractive entry point for prospective investors.