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Analysis: Next Intel CEO to guide new business, maybe Apple deal

Showgoers visit the Intel booth on the first day of the Consumer Electronics Show (CES) in Las Vegas January 8, 2013. REUTERS/Rick Wilking
Showgoers visit the Intel booth on the first day of the Consumer Electronics Show (CES) in Las Vegas January 8, 2013. REUTERS/Rick Wilking

By Noel Randewich and Nadia Damouni

SAN FRANCISCO/NEW YORK (Reuters) - Intel's next CEO is likely to shepherd the top chipmaker into a growing contract-manufacturing business, a strategic shift that could lead to a deal with Apple Inc and give it a fighting chance to make inroads in the mobile arena.

Manufacturing chips on behalf of other companies is a major departure for Intel, which for decades has based its business on using its manufacturing prowess to offer its own PC chips superior to rival products. As PC sales contract and Intel's fabrication plants operate at less than full capacity, the chipmaker sees an opportunity to fill idle production lines while earning new revenue.

Such a move may also offer a backdoor of sorts into large-scale production of chips for mobile devices, where Intel has made little headway after underestimating the impact of the iPhone and iPad and falling behind more nimble rivals.

Intel said last week it will open up its prized manufacturing technology to make chips designed by fellow chipmaker Altera -- snagging its first sizeable customer in a contract manufacturing, or "foundry", business expected to grow.

That has spurred talk of an Apple deal. A source close to one of the companies says Intel and Apple executives have discussed the issue in the past year but no agreement has been reached.

"If you can have a strategic relationship where you're making chips for one of the largest mobile players, you should definitely consider that. And for Apple, that gets them a big advantage." said Pat Becker Jr, of Becker Capital Management, which owned about $39 million worth of Intel shares at the end of last year.

Intel's plan entails heavy capital spending, even as it struggles in its core market and has yet to find enough new demand to fill future fabrication plants. It would also mean getting into a foundry sector that, because it depends on volume to drive business, is highly vulnerable to economic swings and could compress Intel's industry-leading margins.

But it is a bet that analysts say is necessary if Intel wants to remain a top player. The company believes that taking on more contract manufacturing business will not only help fill an upcoming generation of production lines, but help pay for the cost of research to upgrade them.

After Intel upped its capital spending budget by $2 billion to $13 billion this year, speculation grew that Apple could ink a deal to use Intel's leading process technology to make better chips for its iPad and iPhone. Doing so could help Apple end its foundry relationship with Samsung, which has become a fierce competitor with its own smartphones and tablets.

Sunit Rikhi, vice president and general manager of Intel custom foundry, told Reuters last week his group is ready to take on a potential large, unidentified mobile customer, although he declined to discuss Apple specifically.

Intel spokesman Chuck Mulloy said the chipmaker is in constant discussions with Apple, which buys its PC chips, but he would not comment on negotiations about a potential foundry relationship. An Apple spokesman declined to comment.

CEO QUEST

This is all happening as the board of directors at Intel looks for a candidate to replace outgoing CEO Paul Otellini, a talent search that has gone on longer than some insiders expected since it was announced in November.

While Otellini has said he expects to be replaced by an Intel insider, the board of directors has recently increased its focus on potential outside candidates, according to two sources.

Whomever the board chooses must face fundamental decisions about Intel's still-small contract manufacturing business, like how much and how quickly to expand and whether it should supply to Apple, which designs its mobile chips using technology Intel competes with.

"This is potentially huge," said JMP analyst Alex Gauna. "The new CEO will have a very large opportunity to take this to the next level. Those discussions about taking on Apple as a foundry customer are going to be very complex and very contentious."

Intel's chip-manufacturing technology is at least two years ahead of Taiwanese foundry TSMC's or Samsung's. But critics say Intel's "x86" chip architecture is better suited to PCs and servers than to mobile gadgets, which prize low power-consumption and portability.

FUNDAMENTAL DECISIONS

Demand for chips used in smartphones and tablets is far outpacing demand for PC chips, making mobile a must-have market for Intel and other semiconductor manufacturers.

Making Apple's chips however would come at a price for Intel. Such a move could be seen as a capitulation of Intel's own smartphone and tablet chip designs, which are gradually becoming more efficient but have yet to be accepted for use in any major devices.

Complicating a possible deal is that the iPhone maker designs its mobile chips with technology licensed from ARM Holdings. ARM's architecture competes against Intel's and is ubiquitous in mobile gadgets, where Intel's own technology has not caught on.

Santa Clara, California-based Intel has long been king of the PC chip market, particularly through its historic "Wintel" alliance with Microsoft, which led to breathtakingly high profit margins and an 80 percent market share.

Intel's gross margins are expected to be about 60 percent this year, down from 62 percent in 2012 but still more attractive than TSMC's gross margins of around 48 percent.

"They have a business-model question they have to answer. That's something the new CEO will have to wrestle with," said Sanford Bernstein analyst Stacy Rasgon.

Intel has struggled to adapt its powerful processors for battery-powered smartphones and tablets that require much less intensive computing. Its market share for smartphones stands at less than 1 percent, trailing Qualcomm, Samsung and others.

Concerns on Wall Street about slowing PC sales and Intel's lack of progress in mobile have pushed the chipmaker's shares down about 19 percent over the past year.

In Intel's favor is the fact that the sheer amount of investment involved in new generations of semiconductor manufacturing technology has led most chipmakers in recent decades to give up running their own capital-intensive fabrication plants, turning instead to foundries like TSMC.

Intel's agreement with Altera followed deals with minor chipmakers to use Intel's fabs. Otellini in December said "a lot of stuff" was in the pipeline.

Shifting production of iPhone and iPad chips to Intel could lead to an additional $4.2 billion in revenue in 2015, with a gross margin of around 50 percent, according to Macquarie analyst Shawn Webster.

"They've got to have a foundry component to the business, just so they can get the best return on investment for all that capital they're spending," said Evercore Partners analyst Patrick Wang. "The next CEO is the guy or gal who's going to execute that strategy."

(Reporting by Noel Randewich)

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