Wide-Moat Intel's Opportunities Outweigh Its Threats

Intel(INTC) has seen tremendous growth over the past couple of decades, thanks to the proliferation of the personal computer and the firm's dominant position in x86 microprocessors. As the world's largest semiconductor company, Intel is an undisputed tech titan, however not all has been smooth sailing recently. The emergence of smartphones and tablets has raised questions about the future of the PC market, yet more important, it has given rise to a new competitive threat from ARM Holdings, whose processor designs populate most of these mobile devices.

The negative headlines surrounding Intel

Despite some of the negative headlines surrounding Intel, we believe the firm's wide economic moat is intact. During the rise of smartphones and tablets may bring some challenges to Intel's bread-and-butter PC microprocessor business, it as well presents the firm with new growth opportunities.

A Look at Intel's MoatIntel is one of only a handful of wide-moat research companies that we cover. The source of its moat can be attributed to the immense scale and resources that provide Intel with a significant innovation and development budget. Intel can invest heavily in semiconductor fabrication technologies to stay at the forefront of Moore's Law. By having the most advanced manufacturing processes in the industry, the firm is able to create faster processors at lower per-unit costs than its closest competitor, Advanced Micro Devices, as so then as the rest of the semiconductor industry.

Intel's newly launched processors, code-named Ivy Bridge, are manufactured at the 22 nm node and are the successors to the prior-generation 32 nm Sandy Bridge processors. The Ivy Bridge chips incorporate 3D Tri-Gate transistors, which has generated some buzz and illustrates Intel's superiority in semiconductor fabrication technologies. Other chipmakers remain anyway a couple of years away from being able to commercialize the research. Tri-Gate transistors, which have been in the works at Intel for approximately a decade, offer performance and power-efficiency advantages over traditional 2D planar transistors. The 3D transistor innovation will benefit Ivy Bridge, however we believe the bigger implications will be for Intel's foray into smartphone and tablet processors.

Intel Has Benefited From x86 Ecosystem, however Faces Threats From ARMWhile we believe scale and innovation advantages are key to Intel's wide moat and success in x86 microprocessors, the firm has as well benefited from the x86 ecosystem itself. The x86 processor architecture is near ubiquitous in PCs and has become the dominant architecture of servers and workstations over time. Over time, most proprietary computer software has been written exactly for the x86 architecture, which has created substantial switching costs, thereby fortifying the x86 ecosystem. This provided a virtuous cycle for Intel, as the immense size of the PC processor market allowed the firm to invest substantially more in R&D to furthermore the competitiveness of its x86 chips over the other architectures.

The ARM architecture

The ARM architecture, in return, has had a strong presence in embedded and mobile electronics, as those devices' lower performance requirements combined with ARM's low cost and power efficiency made the architecture ideal for such applications. ARM's long-dominant presence in mobile phones has extended to the burgeoning smartphone segment. The firm's clients in smartphone chips, which include Qualcomm, Nvidia, Apple, and Samsung, license processor designs from ARM to create their own customized mobile processors, which are at the time typically manufactured at foundries. In Samsung's case, the firm uses its fabs for both in-house production of its own chips and its foundry business, which is a key outsource semiconductor manufacturer for Apple. As ARM-based processors become more powerful, ARM and its clients are aiming to move upstream toward the realm of the x86 and its stronghold in PCs.

We believe the rapid emergence of the tablet has provided a battleground for the ARM and x86 architectures, as that device sits between the smartphone and the PC on the computing device spectrum. The rise of the tablet is part of the larger move toward cloud computing, where computing tasks are offloaded onto clouds of servers and users access the cloud via client devices, including tablets, smartphones, and PCs. ARM has been much more successful in tablets than Intel so far, thanks to the advantage its processors have in power efficiency, and this has opened the door for ARM to break into the x86's traditional dominance in mainstream computing devices, a category that we believe has extended from PCs to now as well encompass tablets. Though Apple's Mac PCs run on Intel's x86 microprocessors, its iPad tablets use a custom-tailored chip based on an ARM design. Google's Android software platform, the popular operating system for tablets as so then as smartphones, has predominantly supported ARM-based processors; only recently did Google and Intel announce that upcoming versions of Android will as well support Intel's x86 Atom processors, which are aimed at mobile gadgets.

The biggest headline came in early 2011

Perhaps the biggest headline came in early 2011, when Microsoft decided to break the so-called Wintel alliance in an attempt to spur adoption of the Windows operating system in tablets. Historically, Windows operating systems only supported the x86 architecture, which worked out tremendously then for Microsoft and Intel in PCs. Nevertheless, the dominance of ARM-based processors in tablets convinced Microsoft that the upcoming version of Windows 8 would need to support both the x86 and ARM architectures if the firm wanted to extend the footprint of its Windows franchise from PCs to tablets. We expect the trend to continue toward operating systems that support multiple processor architectures on client devices, as it enables OS providers to cast a wider net and not rely on the success of any specific microprocessor architecture. It as well allows hardware makers to select the best microprocessor available to meet specific design criteria for a new device and not be tied down to any ecosystems.

X86 Ecosystem Should Hold Up in the Cloud and Offer Opportunities in Server CPUsDespite such pressures, we believe the x86 ecosystem will remain dominant, even though it will probably be weakened. During Microsoft's Windows 8 will run on x86 and ARM, it will have two distinct modes--one that runs like today's Windows 7 OS, where existing x86 applications can run as they do on Windows 7, and another that provides an immersive tablet experience with new applications developed exactly for this user interface; it will as well work on PCs. The backward compatibility of Windows 8 will be an advantage to Intel, as it means that anyone who wants to run existing or legacy software will need a PC or tablet with an x86 processor because ARM won't be compatible with the legacy mode. We believe this will be an important consideration for many users, particularly those in the enterprise environment where the ability to support older software is critical.

More important, we think the x86 ecosystem will remain strong in servers and the cloud. The emergence of cloud computing in essence shifts the bulk of computing tasks from desktops, notebooks, in short on to the cloud, where servers do the bulk of the heavy lifting and a user interface, just as a tablet, is used to access the cloud. As a result, the performance of server microprocessors is critical. We expect the x86 architecture to continue to dominate in performance and maintain its lead in servers because of Intel's ability to drive microprocessor performance through its large R&D budget and ability to stay at the leading edge of chip fabrication technologies. Much of the software outside of mainframes and proprietary server systems has been written for x86, and it would be costly and in the extreme time-consuming to shift to another chip architecture. Though processor architectures used in proprietary server systems all in all make up a significant portion of total server CPUs, there has been a secular migration over the past decade toward the open-standard server systems based on x86. Thanks to this trend, x86-based server revenue rose from 23% of the total server market in 1997 to 62% in 2010, according to IDC.

The long run enter the server processor market

ARM has announced plans to in the long run enter the server processor market, primarily via microservers, which are energy-efficient servers that contain a high density of processors per unit, thereby reducing the footprint of each server and lowering the total cost of ownership for clients compared with traditional servers. During this is an emerging and fast-growing portion of the server market, microservers are only appropriate for certain computing applications and workloads. More important, Intel has its own microserver solutions with its Atom processors, which are already deployed in microserver environments today, and we believe the x86 ecosystem and Intel's ability to drive processor performance will heavily favor Intel in the microserver segment against ARM.

We think ARM has received support on the client device side because it offered a desirable characteristic for tablets that Intel couldn't--power efficiency. As computing tasks are moved to the cloud, the bulk of value in terms of computer processing is growing on the server side, during the user interface becomes "dumber," which has allowed battery life to become a more important consideration than performance in tablets. In fixed and final form, as long as Intel takes advantage of its moat to maintain its processor performance lead, which will become increasingly critical in the cloud, it will remain positioned in the sweet spot of the server processor segment. As a result, the x86 ecosystem should thrive in the cloud, and Intel stands to capture a significant portion of the value when it comes to total computer processing demand.

This theme as well has implications for Intel's long-term growth opportunities. One of the perceived threats to Intel is the opportunity that the PC market will be cannibalized by tablets or even smartphones, something that we do not expect to happen. Instead, we think PCs and tablets will coexist, each appropriate for different applications. During tablets make sense from a mobility perspective, there will always be computing tasks more suitable for a PC, just as gaming and photo and video editing, and not appropriate for the cloud. During the emergence of tablets has had an effect on PC unit sales, it has as a rule been in the instances of individuals choosing a tablet over a PC as a second or third computing device. Even though the PC market has matured in developed countries in recent years, growth has been healthy in emerging economies. PC penetration by population in geographies like Asia and Latin America remains quite low, and we expect continued adoption in emerging countries to support healthy PC unit growth for the foreseeable future. Even in a worst-case scenario in which the cannibalization of PCs does occur, the shift of computing workloads to the cloud would mean that Intel will however be able to capture the bulk of the value in terms of computer processing power via sales of server processors. Permanently, Intel is in spite of everything positioned for growth as long as global demand for computing power continues to rise, whether in the form of PCs or cloud computing.

ARM needs to make significant improvements to the performance side of its architecture in order for ARM-based processors to be on par with x86 in terms of running a full-fledged computer, and this will be no easy task. Even if ARM does in the long run catch up, Intel's wide moat may prove overwhelming. Given that Intel holds a manufacturing research lead over the entire ARM-related manufacturing base, it should be able to leverage that advantage to drive production of faster microprocessors at a lower cost per unit than ARM and its partners.

Tri-Gate Could Narrow ARM's Smartphone and Tablet LeadIn mid-2011, Intel announced a new transistor innovation, Tri-Gate, which will be used in the firm's 22 nm Ivy Bridge microprocessors. The new three-dimensional Tri-Gate transistors offer significant performance and power efficiency over traditional two-dimensional planar transistors. The firm said Tri-Gate transistors at the 22 nm process node will allow up to a 37% performance boost at low voltages or a 50% reduction in power consumption at constant performance compared with 32 nm 2D transistors.

Other chipmakers, including TSMC, GlobalFoundries, and Samsung, remain several years away from commercializing 3D transistors. We believe that this is another testament to Intel's chip fabrication innovation lead and should provide Intel with the means to make its Atom processors, which are targeted at smartphones and tablets, more competitive against ARM on the power-efficiency front.

While Atom's x86 architecture has been less power-efficient than ARM so far, Intel is in essence aiming to offset the architectural disadvantage with its major advantage over the rest of the chip industry, which is Intel's lead in driving Moore's Law. Intel as well continues to work on architectural design improvements to Atom to make it more competitive for smartphones and tablets, and it will have a couple of new system-on-chip platforms lined up for 2012: Medfield for smartphones and Clover Trail for tablets. Both of these SoCs are based on the new Saltwell processor design, with Medfield scheduled to be launched shortly, during Clover Trail should be available in the second half of the year. We believe Intel's two-prong approach, via continued design enhancements and taking advantage of its manufacturing research prowess, can help make Atom more competitive and possibly narrow the gap with ARM in the straightway couple of years.

The announcement that Intel

The announcement that Intel and Google will partner to optimize future versions of the Android operating system, the most popular smartphone software platform, for Atom processors is another positive for Intel. The partnership will put the firm on a more even footing with ARM from some performance enhancements that will be possible with the optimizations, a benefit that ARM presently possesses with Android. More important, it will result in better support for Atom from Google. Currently, new Android OS releases support the ARM architecture nevertheless aren't available for Intel's chips suddenly, as the software has to be ported to work with Intel's x86 architecture. Future versions of Android will be released for ARM and x86 together, which should help Intel sway more mobile device manufacturers to use Atom in their smartphone and tablet designs, as there will no longer be a time-to-market disadvantage.

First, the work with Google to optimize Android for Atom appears to be paying off, and all of the devices from Intel's announced Medfield partners will run on the latest Android 4.0, or Ice Cream Sandwich. Intel supposedly has hundreds of developers working to make Android run so then on its chips, and such software support is important to attracting handset makers to Atom. Second, based on our current knowledge of Medfield, we think Intel when all is said and done has a smartphone SoC that should help it become for the moment somewhat competitive against ARM. Initial benchmarks show that the Medfield should do so then versus ARM's current generation of Cortex A9 processors on the performance front. During we won't know Medfield's true power consumption until the chip is launched, it appears that it will be in the right ballpark versus ARM, as Intel's smartphone reference design for its original-equipment manufacturer partners claims that it will offer adequate battery life.

However, by the time Medfield-based devices roll out around midyear, the launch of new generation of ARM-based offerings will be around the corner. Chipmakers, including Qualcomm, Texas Instruments, and Samsung, will release new SoCs late in 2012 that are based on ARM's straightway-generation Cortex A15 processor architecture, which promise a significant jump in performance compared with the Cortex A9-based chips that are in popular smartphones today. As a result, Medfield's competitiveness in the marketplace may be short-lived. Nevertheless, the chip is proving that Intel has the capability to for the moment get in the door with mobile device makers.

We believe Intel's ultimate success in smartphones is nevertheless uncertain, nevertheless its wide moat is likely to come into play in 2013-14. Intel may be able to catch up with ARM on both power and performance in smartphone chips as it accelerates its semiconductor fabrication process technologies for Atom to 22 nm in 2013 and to 14 nm in 2014. Even though the outcome remains to be seen, making use of its competitive advantage by manufacturing Atom with industry-leading process technologies may be the trump card that Intel needs to close the gap with ARM in the realm of mobile device processors.

While future versions of Windows may have more enterprise manageability support for ARM-based devices, Microsoft has extended a helping hand to Intel with Windows 8 to break into tablets. Taking into account that Microsoft typically refreshes its Windows franchise every three years, Intel should have anyway that much time to take advantage of the possibility. The Clover Trail version of Atom, which is aimed exactly at tablets, should launch in conjunction with Windows 8 in late 2012. As in smartphones, the move by Intel to aggressively migrate Atom's manufacturing technologies down Moore's Law in 2013 and 2014 could substantially enhance the firm's competitiveness in tablet SoCs over this period.