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Craig Barrett of Intel Corp.: Silicon's valley

It's hardly surprising that Intel Corp. CEO Craig Barrett seems a bit frustrated these days. Despite a sluggish global economy last year, revenues of the world's leading semiconductor company grew by 1 percent to $26.8 billion as net income soared 141 percent to $3.1 billion. Gross margins were a whopping 50 percent, and the company boosted its share of the global market for microprocessors -- the brains of PCs and servers -- to 82.5 percent, from 79 percent the year before, largely at the expense of archrival Advanced Micro Devices.

These kinds of numbers would suggest Intel is an investor darling, right? Hardly. Over the past year, Intel's shares plunged by almost half, to about $17, a loss of more than $100 billion in market capitalization. The main reason: three poor years in the global market for PCs and hence for Intel's microprocessors.

Bad timing for Barrett. It's never easy filling the shoes of giants. Intel's co-founders were Robert Noyce, co-inventor of the integrated circuit; Gordon Moore, author of Moore's Law, which predicted that every 18 months chips would be twice as capable at half the cost; and Andrew Grove, Intel's chairman, whom Barrett succeeded as chief executive in 1998.

Barrett, 64, is no slouch himself. He has a BA, an MS and a Ph.D. in materials science, all from Stanford University, where he taught for a decade before joining Intel in 1974. His problem has been to keep Intel growing in a weak global economy. That's been near impossible given Intel's dependence on the PC industry, which, after years of double-digit growth, declined in 2001. Global PC shipments inched up only 1.6 percent last year, to 136.2 million units, and growth this year will be an unimpressive 6.9 percent, according to IDC, an industry data provider based in Framingham, Massachusetts.

Barrett's long-term strategy has been to diversify into faster-growing markets for chips used in networking and communications devices, such as cell phones and personal digital assistants. As these devices blur the lines between cell phones and computers, they require more and more processing horsepower, giving Intel a wedge into highly competitive markets. The company has made some inroads, especially with flash memory and logic chips for cellular handsets. But it failed in a bid to establish a wireless networking standard, couldn't make a price hike stick and faces very tough competition. The diversification strategy is soaking up billions of dollars in R&D and losing hundreds of millions of dollars annually. Intel's wireless communications and computing group reported operating losses of $294 million last year, up from a $256 million loss the year before. Operating losses in the communications group, aimed at networking infrastructure, were $622 million, only slightly less painful than 2001's loss of $735 million.

Intel can well absorb such losses as a long-term investment. But even if the businesses are successful, their margins are too tight to make a significant difference in the company's bottom line. "The baseband processors for cellular handsets that Intel is seeking to sell now cost about $12 and will fall to about $7 in several years," reckons Allen Leibovitch, who analyzes the market for chips in wireless devices at IDC. That compares with prices of $140 to $150 for Intel's microprocessors.

Having expected the economic recovery to come sooner, some analysts say Barrett overinvested in R&D and new fabrication plants in past years and now faces overcapacity. With a reputation for prickliness at the best of times, such criticism annoys him. Still, he slashed the company's 2003 capital spending to between $3.5 billion and $3.9 billion, down from $4.7 billion in 2002. R&D funding will stay at $4 billion. But analysts say Intel may have to cut more jobs this year to maintain its margins.

Barrett retorts that American pundits are too pessimistic, overlooking fast growth in Asia. Indeed, last year the region became Intel's biggest source of revenues for the first time. The Asia-Pacific market contributed 38 percent of Intel's revenue in 2002, compared with 30 percent in the Americas, 25 percent in Europe and 7 percent in Japan. China in particular is increasingly important as an end market as well as a locale for manufacturing -- a trend that will challenge Intel to continue to innovate.

Barrett spoke recently with Institutional Investor Senior Editor Steven Brull about Intel's longer-term challenges.

Institutional Investor: Recovery has taken longer than you thought. How are you controlling costs?

Barrett: We've been lowering our head count for the past 18 months and ended at about 80,000 at the end of the year, versus just over 90,000 in 2001. There's been a substantial reduction in that.

You've cut Intel's capital spending for 2003 but in February you announced plans to invest $2 billion to upgrade an Arizona plant to make denser chips by late 2005. Critics say you're effectively creating excess capacity.

It takes two years to build a new factory and bring it up into production. You have to balance current demand with what you expect demand is going to be in the future and then the lost opportunity cost to shut down the capacity. I enjoy articles such as the one in The New York Times, which said, you know, "You dummies, why don't you just lower your costs?" Those are the same people who write articles after you lower your costs that say, "You dummies, why don't you have the capacity to ride the upside?" This is a double-edged sword. We're doing what we think is prudent in the way of expense control, but we're continuing to move the technology ahead, continuing to put new products out. The one thing that's kind of a constant in our industry is that technology doesn't acknowledge economic recession. If you cut your technology machine, you imperil your position when the economy recovers.

Still, the PC market remains in the doldrums. Where do you see growth?

The bulk of the growth in our marketplace today is not in established economies such as Western Europe, Japan and the U.S. but in developing economies around the world: Russia, China, India, the other Asian countries, the Middle East and satellite countries around Russia.

Asia ex-Japan became your largest regional source of revenues last year. What's driving growth there?

We're seeing a combination of two things. One is obviously rising consumption in China, India and other Asian countries, everywhere from Australia to Vietnam to the Philippines, Thailand and Malaysia. To some degree it's that manufacturing is moving to those areas. But frankly, it's consumption that's growing, not just the manufacturing.

Do you view the rise of Asia, especially China, as a threat?

There's a constant influx of technology from the U.S. and Western Europe or even Taiwan and Japan. If you look at the playback, it's basically new geographic areas with lower wage rates on the manufacturing side that are gradually moving up to design. Taiwan made its mark in low-cost manufacturing but now has moved to the design stage as mainland China takes over manufacturing. You have to expect that China will continue to move up that food chain from the design standpoint in the same way that India is moving up from a software standpoint. I think that is a textbook case of how capitalism works.

Are China's technological skills and market size a challenge to Intel?

One of the interesting aspects of our business is that it's very R&D and capital intensive. We continue to move the technology forward hourly. That's the primary defense, if you want to use that word. It's the same with anyone else -- whether it's a European company, an Asian company or a Latin American company coming after us. We have to keep moving the technology ahead. It's intellectual content that you have to have to stay ahead of the competition, not the amount or kind of investment. It's quite clear that just as we competed with Japanese companies in the '80s and '90s and with the Taiwanese today, we will compete with mainland Chinese companies in the future. And shame on us if we lose by falling behind in technology development.

How firm is your commitment to Intel Capital, the company's venture capital arm? You have had some tough years.

Intel Capital is an integral part of our investment philosophy, where we invest in the ecosystems of companies that are complementary to our own. And we help bring new capabilities into the marketplace -- whether it's a 64-bit architecture, new communications architecture, whatever. We're committed to Intel Capital's activity. It does get modulated by what's going on in the economy. We invest cautiously with other venture capitalists, and when they slow down dramatically, we're slowed down because of our joint investments.

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