Prize fight: chip maker AMD

In a David and Goliath story, tiny chip maker AMD battles giant Intel for market share with a killer combination: better technology and lower prices.

Intel Corp. and its much smaller yet equally fierce rival, Advanced Micro Devices Inc., have a new place to rumble for microprocessor market share: inside Dell computers. For more than two decades, Intel has held the title of Dell's exclusive supplier of computer processor units (essentially, the digital brains of computers). But in May, the world's biggest PC maker revealed that it would begin offering AMD-made CPUs in its high-end servers before the end of the year. “In the wake of three difficult quarters, Dell has finally recognized that lacking AMD's more powerful Opteron server chips in its lineup was hurting its sales and its reputation,” said Punk, Ziegel & Co. analyst JoAnne Feeney in her May 19 research report.

Kevin Rollins, president and CEO of Dell Inc., downplayed the decision in a televised interview. Smiling for the camera and seemingly praising Intel's products at every opportunity, he pointed out that high-end servers account for a small fraction of his company's business. Rollins repeatedly dodged questions on whether Dell plans to use AMD chips in more of its products, but industry watchers believe the stage is now set for AMD to battle its way into the PC maker's other servers, laptops and desktop computers. The stakes are high. According to Prudential Equity Group estimates, AMD could capture US$1 billion in annual sales by penetrating a quarter of Dell's products.

The Dell announcement comes at a time when AMD, based in Sunnyvale, Calif., appears to have the momentum in its fight with Santa Clara neighbour, Intel. Over the past three years, AMD has grabbed share from Intel–most noticeably in the server segment–and now holds a roughly 17% slice of the market. A big reason: AMD has hit Intel with a killer combination of better technology and lower prices. The prize: shares of AMD (NYSE: AMD) have more than quadrupled in value over that period.

Intel seems particularly vulnerable lately. Plagued by supply problems, it posted disappointing fourth-quarter results and strained relationships with key customers. Its stock (Nasdaq: INTC) has steadily fallen 30% since the beginning of the year. Nevertheless, Intel remains the heavyweight champion of the microprocessor industry, with an estimated 80% market share. It boasts one of the most well-known brands in the world. Plus, the chip giant spends roughly fives times more on research and development than AMD. Can the underdog in this matchup rise to the challenge and win a bigger chunk of Dell's business from Intel?

AMD's team of talented chip engineers should give the company a fighting chance at such a prize. Faced with the problem of slowing growth, Dell is placing more focus on beating its competition on technology. The PC maker, based in Round Rock, Texas, will likely need to beef up on AMD chips to do that.

Nathan Brookwood, an analyst at the IT consulting firm Insight 64, says AMD's desktop computer and server chips run faster, use less power and generate less heat than Intel's competing products. According to Brookwood, those last two benchmarks have become increasingly more important to corporations. “Technology has gotten to the point where the electricity needed to run computer networks and cool them is now a bigger part of most companies' IT budgets than the actual cost of buying the systems,” he says. Brookwood does, however, give the performance edge in laptop microprocessors to Intel. Those chips, he explains, came out of Intel's Israeli design team, whose practices have since been adopted by the rest of the company.

AMD's technological advantage, however, may be short-lived. Analyst Feeney says Intel's new generation of chips–based on its new “core microarchitecture” and slated for release beginning in the third quarter–will “help Intel catch up to AMD's current offerings and surpass them in some cases.” Nevertheless, AMD plans to counter with its own new releases over the next year. What's more, Brookwood believes AMD has built up its engineering expertise to the point where it will now trade chip performance leadership with Intel, much the way ATI Technologies Inc. (a recently rumoured AMD takeover target) and Nvidia Corp. swap technological advantages in the computer video card market. “Neither is going to leave the other in its dust,” Brookwood insists.

Even if AMD matches up evenly with Intel on general performance benchmarks, Brookwood offers another reason why Dell may need a wider range of AMD products: a company's overall chip design can't be everything to everyone. For example, Intel's microprocessors may be a hit with laptop users since they maximize battery life. But in a recent head-to-head contest in PC Gamer magazine, the AMD Athlon FX-60 “spanked” Intel's Pentium Extreme Edition 955 on several benchmarks, including “straight-up gaming performance.” So if Dell is truly serious about offering the best technology on the market for all of its customers and at all times, it will likely need a wide range of both Intel and AMD products.

On the other hand, aggressive Intel pricing could prevent AMD from dealing any devastating blows to its rival's Dell business. Although the price gap has closed over the past few years, AMD products are generally cheaper than Intel's. But the chip giant recently dropped prices to grab back share from its scrappy rival. And a price war clearly favours Intel.

Last year, Intel boasted gross margins of 59.4% and profit margins of 22.3%, while AMD's figures were 40.9% and 2.8%, respectively. So Intel appears to have much more room to bring down its prices than AMD. If the two competitors dig in for a long bout, Intel's massive size will become an even bigger advantage. Intel's 2005 cash from operations came in at a whopping US$14.8 billion, which helped the chip giant plow US$5.8 billion into fixed assets and pay out US$2 billion in dividends. Over the same period, AMD churned out US$1.5 billion in cash from operations. That sum was US$30 million less than the company shelled out for fixed assets in 2005. In May, AMD announced plans to invest US$2.5 billion in a German chip factory over the next three years. So AMD seems to have many years of heavy investments ahead of it.

Nevertheless, AMD could suddenly snatch a much larger piece of Dell's business–if Intel's supply chain takes another misstep. Last year, the microprocessor mammoth underestimated the demand for its chip sets (components essential for a CPU to “talk” to other parts of the computer). So PC makers with Intel microprocessors couldn't build their computers. According to a September 2005 Needham research note, Dell and Lenovo were two computer companies affected by Intel's lack of inventory. Another PC manufacturer, Gateway Inc., was reportedly so frustrated with Intel's supply blunders that it substituted an AMD chip in its retail desktop computers during the fourth quarter of last year.

That said, AMD has had its share of problems delivering products to customers, too. In the past, Brookwood says, the company has essentially told PC makers “we've forgotten how to make that chip, so we can't get you any.” When AMD launched its Opteron server chip three years ago, some industry watchers were skeptical the company could deliver a high level of service. But since that product introduction, Brookwood says, AMD has been a predictable and reliable supplier. So the greatly improved chip maker could happily come to Dell's rescue if Intel's supply chain falters once again.

AMD has set its sights on an ambitious 30% share of the market, something the 37-year-old company has chased but never achieved. If the industry underdog can knock out more of Intel's chips from their slots inside Dell computers, that lofty goal seems within reach. Some PC makers may be hoping AMD gets a lot bigger. After all, a shift in the microprocessor market away from a monopoly and toward a duopoly should help to keep the pace of innovation high, product choices wide and prices low. So although the world's biggest PC maker may sing Intel's praises in public, it just might secretly be in AMD's corner.