Intel Corporation (NASDAQ: INTC)
Q2 2008 Earnings Conference Call
July 15, 2008 5:30 PM ET

Management Summary

Operator

Good day, ladies and gentlemen and welcome to the second quarter 2008 Intel Corporation earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today's call, Mr. Kevin Sellers, Vice President of Investor Relations. Please proceed, sir.

Kevin Sellers, Vice President of Investor Relations

Thank you and welcome everyone to Intel's Q2 2008 earnings conference call. Joining me on today's call are Chief Executive Officer Paul Otellini and Chief Financial Officer Stacy Smith. This call is being webcast live and a replay will be posted to our website at approximately 5:00 PM Pacific time and will remain there for approximately two months.

As usual, Paul will be discussing the highlights and progress of the quarter and Stacy will then provide details on our financial performance in Q2, as well as the outlook for both the third quarter and full year 2008. Following Stacy's comments, we will be happy to take questions.

A few important items before we begin. First, the press release of our earnings went out at approximately 1:15 PM Pacific time and is now posted on our investor website, intc.com, along with updated financial statements for anyone who still needs access to that information. Also, if during this call we use any non-GAAP financial measures or references, we will post the appropriate GAAP financial reconciliations to our investor website.

As we begin, let me remind everyone that today's discussion contains forward-looking statements based on the environment as we currently see it and, as such, does include risks and uncertainties. Please refer to our press release for more information on the specific risk factors that could cause actual results to differ materially.

With that, let me now hand it over to Paul.

Paul Otellini, President and Chief Executive Officer

Thanks, Kevin. Our second quarter results were very positive on a number of fronts. First, revenue for the quarter was a record, the fourth quarter in a row that we achieved such a result. Demand for our leading edge computing products around the world continues to be strong, with revenue and unit shipments toward the high end of the seasonal norm, when factoring in the divestiture of the NOR business.

We realized record unit shipments in mobile microprocessors, chip sets and wireless communication units in the second quarter.

Our focus on lowering costs and improving efficiency continues to provide considerable operating leverage, with operating income growing 67% from a year ago. For the second quarter in a row, we bought back $2.5 billion worth of stock, returning cash to our stockholders.

Our 45-nanometer manufacturing process is performing superbly. We remain on track to ship over 100 million units before the end of the year on this process technology. At this stage of our process ramp, yields and throughput times are better then at the same time on our 65-nanometer ramp. These results are lowering unit costs ahead of our original plans, and are providing us with increased flexibility in meeting diverse customer requirements. We will reach the 45-nanometer shipment cross-over point for microprocessors during this, the third quarter.

Now let me briefly discuss a few product highlights.

In servers, we had record channel shipments. This demonstrates the demand for our products coming from small and medium businesses around the world continues to be healthy. We also enjoyed some noteworthy design wins at both Cray and DreamWorks, reflecting that our current and future product roadmaps are delivering the performance that meets the most demanding customer requirements.

In mobile, we enjoyed very strong unit growth, both sequentially and year over year. As notebook computers continue to decline in price, we see demand growing in response. We saw notebook unit shipments crossover desktop in the overall client PC category in the second quarter; that is sooner than we had expected.

We launched our new Atom processor during the second quarter and are exceeding our ramp targets as demand for this new product is very robust. We expect unit shipments of Atom processors to grow sharply in the second half.

In summary, we were very pleased with our second quarter results. The strategic direction we laid out two years ago at our investor meeting, coupled with our restructuring efforts, are coming together and yielding tangible results that we committed to our stockholders. Our product line is superbly positioned, our new growth initiatives are ramping and showing promise, and our manufacturing execution is outstanding.

In the third quarter we plan to bring exciting new products to market, such as our new Centrino 2 platform launched just yesterday, as well as Dunnington, our six-core server processor targeted at high end server workloads, scheduled to launch later this quarter. These are the kinds of innovations that create real differentiation for our customers and allow us to maintain product leadership.

A final word on the economic environment. We are very aware of the global economic issues that dominate the financial markets these days. We are watching these very carefully. In the first half of 2008 we saw order patterns play out as anticipated at the beginning of the year. Inventories remain at healthy levels and our global footprint is helping us benefit from demand for internet computing.

As we look into the third quarter, we see continued healthy demand for our products, leading us to the third quarter outlook that we provided.

Let me now turn this call back over to Stacy.

Stacy Smith, Chief Financial Officer

Thanks, Paul. Intel delivered strong financial results in the second quarter. Better than expected demand in the microprocessor and chipset businesses led to record second quarter revenue of $9.5 billion.

Compared to the second quarter of 2007, revenue grew 9% with gross margin up more than 8 points. Operating profit was up 67% year over year and operating income as a percentage of revenue was up 8 points year over year to 24%.

Revenue for the second quarter was above the midpoint of the range forecasted in April and down 2% from the first quarter. Excluding the revenue associated with the NOR business, revenue was flat to the first quarter, at the high end of the seasonal range.

Microprocessor unit sales were above the seasonal pattern, and average selling prices were low. More than half of total revenue, $5.4 billion, came from the Digital Enterprise Group. Revenue from this group was flat compared to the first quarter, and up 11% from the prior year. Microprocessor revenue in the Digital Enterprise Group showed particular strength, with revenue up 14% from the second quarter of 2007.

The Mobility Group accounted for more than one-third of total revenue. This revenue, $3.8 billion, was up 3% from the first quarter and up 15% from the prior year.

Looking at a geographical breakout, all geographies experienced year-over-year growth in the second quarter. After adjusting for the impact of the NOR Flash divesture and supply agreement with Numonyx, all geographies performed a little better than average seasonality.

Gross margin dollars were $5.2 billion, flat compared to the first quarter. Gross margin percentage of 55.4% was up over 1.5 points from the first quarter and up over 8 points from the second quarter of 2007. Versus the midpoint of the outlook range set in April, second quarter gross margin was down 0.5 points. A little less than 1 point decline came from average selling prices being lower, primarily due to the growth in shipments and the lower-priced segments of the notebook market.

R&D and MG&A were approximately $2.9 billion, within the forecasted range of $2.8 billion to $2.9 billion and up 3% from the first quarter. In addition, we had restructuring and asset impairment charges at $96 million, which was lower than the outlook that we provided of approximately $250 million, as an assessment of capacity resulted in less restructuring and asset impairment charges.

The number of employees is down by 2,700 from the first quarter to below 82,000 primarily due to employees transferred to Numonyx. As we complete the second year of the restructuring program announced in 2006, the number of employees is down more than 20,000 from the second quarter of 2006.

Gains, losses on equity investments and interest and other income of $58 million was lower than our outlook of $75 million and lower than the first quarter of $109 million. Relative to the first quarter, improvements in the trading asset portfolio were offset by lower interest income and impairments of marketable equity securities.

The provision for taxes in the second quarter was at a 31% effective tax rate, lower than the 33% previously forecasted due to tax settlements. On the balance sheet, total inventories were flat to the first quarter at $3.3 billion. Total cash investments comprised of cash, short-term investments and fixed income trading assets ended the quarter at $11.5 billion, $1.7 billion less than the first quarter. Cash flow from operations was over $2.5 billion. Capital spending was $1.2 billion, dividend payments were $800 million and stock repurchases were $2.5 billion.

As we turn now to the outlook for the third quarter, please keep in mind unless otherwise specified, the forecasts do not include the effects of any new acquisitions, divestitures or similar transactions that may be completed after July 14. I will use the midpoint of the forecast ranges when making comparisons to specific periods.

We are planning for revenue to be between $10 billion and $10.6 billion. The midpoint of this range would be an increase of 9% from the second quarter. On a year-to-year basis, the outlook anticipates revenue growth of 2%. Excluding the decline in NOR revenue, the growth would be approximately 6% year over year.

Our expectation for gross margin percentage in the third quarter is 58%, plus or minus a couple of points, 2.5 points higher than the second quarter as microprocessor unit volume increases in the seasonally up third quarter, and as unit costs decline on 45-nanometer products. Looking beyond the third quarter, as volume increases and costs decline, we expect gross margin to improve further in the fourth quarter.

Spending for R&D and MG&A in the third quarter should be approximately $2.9 billion. Additionally, in a separate category for restructuring and asset impairment charges, we expect expenses of approximately $60 million. Depreciation is forecasted to be approximately $1.1 billion.

Our estimate for gains and losses from equity investments and interest and other income is a net loss of $30 million. We maintain the midpoint of our outlook for gross margin for the full year at 57% and have narrowed the outlook range to plus or minus a couple of points.

Spending for R&D and MG&A for the full year is now forecasted to be approximately $11.7 billion. R&D spending is forecasted to be approximately $6 billion, flat to the prior forecast, and MG&A spending is forecasted to be approximately $5.7 billion, up $200 million from the prior forecast, primarily due to legal and profit dependent expenses.

The tax rate for each of the remaining quarters in the year is expected to be 33%, unchanged from our prior outlook.

Second quarter revenue growth of 9% and operating profit growth of 67% year over year marks the end of a strong first half. As we look into the second half of the year, we are planning for growth and improving financial results, driven by our product leadership, the ramp of the Atom processor, the build out of three 45-nanometer high volume factories, declining unit costs and the impact of our restructuring program.

With that, let me turn it back to Kevin for Q&A.

Kevin Sellers, Vice President of Investor Relations

Thanks Stacy and Paul. Before we begin our Q&A segment, I want to remind the financial community of our upcoming Intel Developer Forum taking place on August 19 through August 21 in San Francisco. There will seven keynotes during the forum covering a wide range of technology trends and Intel product plans from the Digital Enterprise to ultra mobility to software. We will also hold a number of briefings for investors and analysts as well. For registration and other information, please go to intel.com/idf.

We will now be happy to take your questions. In order to allow more of you to participate on this call, we will limit each person to one question and one follow-up, if you have one. The operator will introduce each of you and prompt your question, and I will then ask if you have a follow up. The operator will then introduce the next question. We are now ready for our first question.

Q&A

Operator

Your first question comes from John Pitzer, Credit Suisse.

John Pitzer, Credit Suisse

Good afternoon. Just quickly on gross margins for the June quarter being below midpoint, you are pointing to the low end notebook market. Was that all Atom driven or were you still selling some Celeron to that market?

If it was all Atom, how do we get comfortable about gross margin progression in September, as Atom ramps and becomes an even bigger percentage of the overall mix?

Stacy Smith, Chief Financial Officer

Yes it was not Atom. Atom launched in the second quarter, but the unit shipped on Atom were pretty small in the second quarter. We expect it to ramp rapidly into the second half of the year.

If it was what I would call the traditional notebook market, as Paul said, that is now more than 50% of the market, we are seeing a lot of unit growth in emerging markets. We are seeing growth in channels such as the retail channels. That growth is good for us, but it tends to be at a lower price point. So you are seeing TAM expansion at some of these lower price points and that brought the average price down in the second quarter from what we expected.

Kevin Sellers, Vice President of Investor Relations

John do you have something else?

John Pitzer, Credit Suisse

Yes, just real quick. Given the buybacks through the first half of the year, what can we expect in the back half? You guys are growing at a pretty significant clip relative to what you did in 2006 and 2007. What's the philosophy there?

Stacy Smith, Chief Financial Officer

I had said back in Q1 that the cash balance was a little higher than we were targeting. We brought down the cash balance by about $3 billion over the course of the first half and we have done $5 billion worth of buybacks between Q1 and Q2. The cash balance is getting more into the range of what I'm targeting. At this point, I'm not going to give a buyback forecast, nor am I going to give a cash forecast for Q3.

Operator

Your next question comes from Tim Luke, Lehman Brothers.

Tim Luke, Lehman Brothers

Stacy, just in guiding a fairly solid revenue outlook in the $10 billion to $10.6 billion, could you give us some framework for how you perceive the desktop area to be proceeding? Again, it sounds like you are expecting a fairly robust notebook and perhaps even, as on the lower end, notebook forecast. Could you give us some color on desktop, notebook, server?

Stacy Smith, Chief Financial Officer

I would point back to what we have seen so far in the first half. We really have seen demand holding up across the different segments of the computing-related business, with particular strength in the notebook growth that we spoke about at some of these price points. And then in the server market, I think the strength of our product line really benefited us in Q1; Q2 tends to be a seasonally lower quarter for servers but I would expect that to also be strong as we get into the second half.

I think underlying your question is demand. We saw demand pretty normal through the second quarter across the segments of our business and across the different geographies.

Kevin Sellers, Vice President of Investor Relations

Tim, did you have a follow up?

Tim Luke, Lehman Brothers

Just as a follow up, obviously you are holding the gross margin for the full year guidance and guiding it up fairly meaningfully in the third quarter to the 58% range. Could you just provide a little bit more color on what gets you there, given the strength you are seeing in the lower end notebook segment and the mix there? Thanks.

Stacy Smith, Chief Financial Officer

Sure. It's a pretty simple margin reconciliation going from Q2 to Q3. There are two elements that are worth roughly the same amount of gross margin improvement. We see our costs improve quarter on quarter pretty dramatically as we go from Q2 to Q3, and then we see volume and the CPU segment up seasonally. Those two things get you to 58%.

Operator

Your next question comes from Glen Yeung, Citigroup.

Glen Yeung, Citigroup

Thanks. A question about the outlook for revenues. It is good in Q2, you are guiding strongly in Q3. To what extent is your confidence been helped by share gain and/or the Montevina launch? Does that give you some confidence in how you look at Q3?

Paul Otellini, President and Chief Executive Officer

Glen, I think it's a combination of things. What we have seen from our customers is, I think the overarching comment is on the notebook market accelerating around the globe at multiple price points.

We would also expect and will see more of Atom-based notebooks in the third and fourth quarters, and that is why we will break those numbers out for you in our commentary so that you can draw some trend lines around those.

But in general, we were able to cover the shipment shortfall on Montevina in Q2 with Santa Rosa. We replaced all that volume so our customers were able to keep on shipping. Now Montevina is ramping very rapidly in the consumer segments that were launched today or yesterday.

I won't comment on share gain but I will let the numbers speak for themselves when they all come out. It has to be pretty clear that with the kind of mobile volumes we had in the second quarter that we did pretty well.

Kevin Sellers, Vice President of Investor Relations

Glen, you had something to follow up?

Glen Yeung, Citigroup

Maybe just going on from that response, you talked about the low end of the notebook market taking some mix in Q2, but now you've got Montevina coming forward for you in Q3. Does that sort of stem the shift towards low end, or do you think it's really more a function of emerging markets versus Western markets?

Paul Otellini, President and Chief Executive Officer

I think it is a bunch of things. A lot of this is dependent on the economy. The prime purchaser of notebooks still remains, as a segment business, large enterprise. They tend to buy relatively high end notebooks and Montevina will start shipping into that segment later this quarter when we launch the Centrino 2 Pro product line.

So that is one that we are fairly bullish about for the second half as that ramps and replaces the preexisting SKUs that are out there. But in general, I think what we are seeing is just a fundamental shift to notebooks. We've been seeing it for years and the crossover happened six months sooner than we thought.

Operator

Your next question comes from Ross Seymore, Deutsche Bank.

Ross Seymore, Deutsche Bank

You talked about the pricing on the notebook side of the market. Can you tell us a little bit about what's going on in pricing in desktops and servers please?

Stacy Smith, Chief Financial Officer

Sure. We are not going to give you any ASP granularity in each of those areas, but in servers we had a very strong Q1 in MP and in Q2, DP was a bit heavier so that tends to drive the mix a little bit to the lower priced numbers. I would expect MP to pick up in the second half of the year, as is traditional. The fourth quarter is normally the big server quarter but as you can tell, we are being a little bit cautious about that given the overall economic environment.

In terms of desktop, there are two trends. There is a continuing trend in emerging markets of lower-priced desktops but there is also a trend for refresh rates in corporate around our vPro product line, which have above average selling prices. So the combination of the two has kept the desktop pricing, on average, relatively constant.

Kevin Sellers, Vice President of Investor Relations

Ross, you had something else?

Ross Seymore, Deutsche Bank

Yes just really quick on the ESO line, it seems like year over year your headcount is down a lot but the stock comp expense keeps going up. Can you give us a little bit of the background as to why that would happen and what your expectations are for that line going forward?

Stacy Smith, Chief Financial Officer

I think as we run the model, I would actually have to go back and double check this Ross, but I think it is as we run the model, as volatility goes up a bit the stock option expense goes up a bit. You are right, we have quite a few fewer employees and we have not expanded the stock option program in terms of number of options granted per employee so I think it's just the volatility.

Operator

Your next question comes from James Covello, Goldman Sachs.

James Covello, Goldman Sachs

Paul, last quarter you gave us a little bit of color about the NAND business and your thoughts around fixing it, one way or the other. I wonder if you could update us on where we are there?

Paul Otellini, President and Chief Executive Officer

Well, I won't give you a lot more color than I gave you last quarter, James, but we are taking some actions to limit the amount of supply growth in this environment. As you know, the NAND pricing continues to still be very weak so we are focusing on supply and on cost.

At the same time, we are focused on trying to get a better pricing environment for our products by shifting some of it to more innovative stacking products into SoCs. At the same we're doing that, we're still looking for longer term solutions, I have not wavered in my commitment to have this business not be a long-term drag on our P&L.

Kevin Sellers, Vice President of Investor Relations

Jim, you had something else?

James Covello, Goldman Sachs

Yes, if I could just follow up on the DreamWorks win. Could you just help us understand, in the competitive situation there, was that your products versus AMD's old products before they introduced the new Barcelona chip, or was that decision made before AMD was able to ramp the new chip?

Paul Otellini, President and Chief Executive Officer

It was based upon our roadmap going forward versus their assessment of competitive roadmaps going forward. They don't make one quarter or even a one-year decision because the tremendous amount of the effort here is involved in software optimization. The software optimization around Intel is relatively unique versus other vendors' products.

So I consider this a multi-year win; it's a multi-year framework that binds it together. It is software and hardware and I think it is reflective of the very competitive roadmap we have, not just in servers but also in workstations as Larrabee comes on.

Operator

Your next question comes from Sumit Dhanda, Banc of America Securities.

Sumit Dhanda, Banc of America Securities

Stacy, you noted that part of the, call it the small miss on gross margins, was because of 1 point incremental drag from lower ASPs. Was that incremental to your expectations? Because my recollection is a couple of one-timers were disappearing, your inventory reserves on chipsets, NOR flash was obviously contributing to better margins and you did have a better unit cost structure into the quarters. I was just curious about that.

Stacy Smith, Chief Financial Officer

It was slightly less than 1 point and it was to the outlook that I set. If you look at this from a quarter-on-quarter basis, with the exception of the ASP, we got the good news from the two areas I was expecting: we had articulated that we have some good news; as we had chipsets that qualified for sale in the quarter and we were shipping them in the second quarter so we got good news there. We got good news from the NOR divestiture, the piece that was unexpected to the outlook was being a little bit down in ASP.

Kevin Sellers, Vice President of Investor Relations

Sumit, any follow ups?

Sumit Dhanda, Banc of America Securities

I just have one separate follow up. On Atom, there has been talk about constraints with respect to supplying the existing demand. Could you update us on what's your sense is versus market expectations on your supply? Is that constraining your outlook for Q3 in any way, shape or form?

Paul Otellini, President and Chief Executive Officer

The short answer is no, it is not constraining our outlook for Q3. It is well within the bounds of the $10 billion to $10.6 billion that we gave you. We have been increasing our planned production of Atom for this year and next every 40 days since last November as demand continues to roll up, not just in NetBook segments but also in embedded and consumer electronics segments. It looks like the design wins are really quite robust. We continue to add more and more zeroes to the numbers we are building for this year and next year. I don't expect it to be any kind of limiter for revenue growth this year at all.

Stacy Smith, Chief Financial Officer

Sumit, if I can just add on that, the supply constraints we are seeing with Atom are specifically the back end, the test constraints. We have plenty of die and as Paul said, it's well contained inside the revenue guidance we gave. But as demand is going up month by month we are jumping to keep enough test capacity in place for the demand.

Paul Otellini, President and Chief Executive Officer

And then the other part of that, Sumit, is to make sure we have enough chipsets. I mean, at the same time the Atom processor growth is jumping up we have to also be able to build a chipset for each of those, which is one of the reasons you saw our factory utilization assessment go up over time in this quarter rather than down.

Operator

Your next question comes from David Wong, Wachovia.

David Wong, Wachovia

Thank you very much. Following up from the earlier question, as the Atom ramps in volume over the next two quarters, presumably primarily for notebooks, is the Atom gross margin below, above or roughly equal to overall corporate gross margin?

Stacy Smith, Chief Financial Officer

Just to make sure it's clear -- I think it is, but to make sure it's clear -- the ramp of Atom is encompassed in a 58% gross margin in Q3 and what I expect to be a higher gross margin in Q4.

My view of Atom hasn't changed from what I showed at the analyst meeting. If you will recall, I was showing the Atom platform, I used end of 2009 as the comparison point because at that point we had ramped Atom volume, we had ramped quad core volume to be a fairly significant percent of the total. What I showed you at the time was inclusive of the chipset, so the CPU plus the chipset. I expected the Atom platform to be about 10 product margin points lower than the mainstream of the product line, which was dual core, and quad core to be about 10 product margin points higher than that.

So my view hasn't changed and I'll update that again in Q1 next year when we have the investor meeting.

Kevin Sellers, Vice President of Investor Relations

David, do you have anything else?

David Wong, Wachovia

One other thing. Did the MP server processor, then specifically Tigerton processor shipments, grow sequentially in June?

Stacy Smith, Chief Financial Officer

I don't think I want to give you that granularity. The Tigerton, it probably did, I don't have the number at the tip of my fingers, but given that it is a relatively new product and it continues to ramp. What I was talking about earlier was the mix between MP and DP, and that was encompassing both old and new products.

Operator

Your next question comes from Uche Orji, UBS.

Uche Orji, UBS

Paul, just a quick question on Atom. What is the relative gross margin of Atom versus Celeron? As we ramp this product in the second half, do you see this possibly replacing the low-end Celeron products in notebooks? If so, what will the impact be on the net gross margins?

Paul Otellini, President and Chief Executive Officer

Let me answer the second part of that and I will throw it back to Stacy for the first part, which I think he has already answered but he can try it again.

At this point in time, we do not see it replacing Celeron. If you look at the products that are being built, the NetBook products that are being built around Atom, they are all lower priced, lower features, smaller screen size notebooks aimed at first-time buyers or the second, third or fourth machine in a household. I don't see it cannibalizing, at least in terms of current sales out. I think we really have hit on a new product category here.

Over time, we are still sorting out the brand activity in our mainstream notebooks. It is clearly Centrino and Core is where the thrust is going to be, and we will sort out and ultimately talk about where Pentium-based notebooks and Celeron-based notebooks live as these categories sort themselves out.

But I think its premature to say that, except that we don't see any cannibalization.

Stacy Smith, Chief Financial Officer

Unfortunately I am not going to go into any more granularity then I did at the last analyst meeting. We expect this to be a very healthy product margin product. What we are seeing today is demand that's exceeding our expectations and it's kind of all in to my gross margin forecast for the year and for Q3.

Kevin Sellers, Vice President of Investor Relations

Uche, do you have anything else?

Uche Orji, UBS

Yes, I do actually. Let me just circle back a little bit to Montevina. Obviously that shouldn't have an impact in this quarter; but is it possible, however, that in terms of the [inaudible] build, that you may have displaced some business as a consequence from Montevina.

Is that something you would hope to recapture in Q3, hence the gross margin impact that we see remaining strong? I mean, I just wanted to first of all understand what really happens with that push out? I understand it was something to do with your [inaudible]. Is it possible to clarify that? That would be helpful. Thanks.

Paul Otellini, President and Chief Executive Officer

The principle reason was graphics and integrated graphics and then the radial as well. The combination of those two was about a 30 days slip on the consumer SKUs.

A couple things on back-to-school. First of all, as the industry has gotten more efficient over the last few years, particularly in notebook manufacturing, the cycle times have come down both from a transit standpoint and assembly standpoint. Our customers are all using hubs and so forth nowadays as manufacturing techniques.

So the earliness that you used to see in shipping semiconductors into manufacturers to hit something like back-to-school weekends is a lot shorter than it used to be. As a result, I don't think we missed much, if any, of the back-to-school cycle.

Some of our customers are doing multiple SKUs and will have multiple back-to-school refreshes and Montevina will be prominent in those second rounds. I think the goodness of the product stands for itself. There are still not really benchmarks coming out on our new products versus competition's new products, but when they come out, given our testing internally, I expect we will do very, very well.

Operator

Your next question comes from Chris Danely, JP Morgan.

Chris Danely, JP Morgan

A question or curiosity on the ASP trends in laptops. It seems that the emerging markets are what drove the downward trend in ASPs, but it seems to me that emerging markets have always been the big driver there. I'm wondering why now would it cause this sudden downward trend in ASPs and why wouldn't that continue?

Paul Otellini, President and Chief Executive Officer

I didn't say emerging market, if we did, I misspoke. What is happening in the notebook business, and we showed this graphically at the analyst meeting, is that consumer purchases of notebooks as a percent of consumer PC purchases has grown from 15% to 20% up to 50%, which is roughly where corporate is. Corporate is a little bit higher than that.

What's happened is the consumer market, on a worldwide basis and for PCs, is shifting to notebooks. Consumer price points on notebooks are lower than enterprise price points on notebooks because of the typical configurations and the builds behind them. So I think it is nothing more than price/volume expansion of the consumer portion of the business on a worldwide basis.

As NetBooks ramp up in the second half of this year, those I do expect to be predominantly focused on emerging markets, but we are just seeing the beginning of that now.

Chris Danely, JP Morgan

Paul, why wouldn't that continue or why wouldn't you still have ASP pressure going forward?

Paul Otellini, President and Chief Executive Officer

That's why we are going to give you some color on Atom over time as a separate line item, because I don't want it to, if you will, color the overall ASP of the core business. We'll give you some guidance on that as it gets to be a big number.

Chris Danely, JP Morgan

Paul, could you just give us your sense on demand out there? I mean, we all read the papers and stuff like that. It seems like we all understand what is going on in U.S. What are you seeing in particular out there in China as far as demand goes?

Paul Otellini, President and Chief Executive Officer

Well, specifically in China, the quarter had an early interruption, obviously, with the Chengdu earthquake. Intel and virtually everyone that I know that operates in China had some impact early in the quarter from the disruption of sales for essentially a big part of the country, the western part of the country.

That notwithstanding, the other trends in China are very good. Olympics build up has got a lot of excitement. There are WiMAX trials on notebooks in China for the yachting events, a lot of excitement around that.

I would expect that as the replacement machines and rebuilding schools and so forth happen in China, that there will be some recovery from the demand that was lost earlier this quarter.

Operator

Your next question comes from Hans Mosesmann, Raymond James.

Hans Mosesmann, Raymond James

Paul, can you explain what the direction is going forward in terms of chipset support by third parties? Historically there used to be various players like Avia, Asus, and ATI and even NVIDIA. Now that some of those guys can't do that for lots of reasons, what is the strategy going forward?

Paul Otellini, President and Chief Executive Officer

Well our overall strategy on chipsets is to continue to build the best in the world and to drive as high a percentage of our microprocessors with chipsets as the market demands.

We've done exceptionally well in notebooks and have historically done well in servers and okay in desktop. A lot of the companies you talked about in your litany there were desktop suppliers, low end desktop suppliers in particular, and they have made economic decisions to not participate in that marketplace.

There are some structural changes coming up in terms of the kinds of busses that we will expose publicly with the Nehalem generation; much has been written about that, you will see more about that at IDF.

But I was very pleased to see this week that NVIDIA announced that they will do SLI support for Nehalem using the PCI Express bus, which is an open, non-proprietary bus.

Kevin Sellers, Vice President of Investor Relations

Do you have a follow up, Hans?

Hans Mosesmann, Raymond James

Yes. Can you remind us in terms of tick-tock hit that you get in terms of gross margins when you ramp early next year at the 32-nanometer node, what's the usual gross margin hit in terms of points that you would expect because of that?

Stacy Smith, Chief Financial Officer

What I showed you at the analyst meeting is still how I'm viewing this, which is in the year in which we launch a new process technology, so 2009 will be the year in which we launch 32-nanometer process technology, you tend to see a couple of points of elevation in other cost of sales off of a base of a couple of points. That's over the year. It can spike a little bit more than that in a specific quarter. But it tends to be a couple of points of gross margin.

Now keep in mind, some of that is a classification of the research and development hedge in the year in which they are working on a process that is going in production, they are classified as other cost of sales. And the year in which they are working on a process that is not going in production, they are classified as R&D. That's one of the reasons you saw our spending this year go up was that classification. That was about a couple hundred million dollars worth of spending in 2008.

Hans Mosesmann, Raymond James

Okay so a couple of points basically in the first half of next year?

Stacy Smith, Chief Financial Officer

A couple of points on the year and it will vary.

Hans Mosesmann, Raymond James

But front end loaded?

Stacy Smith, Chief Financial Officer

The graph I showed you at the analyst meeting showed yes, that it will be higher in the first half of 2009.

Operator

Your next question comes from John Barton, Cowen.

John Barton, Cowen

Paul, you talked about better than expected strength from the Atom processor. When I think about sources of demand I put it in basically three buckets: incremental first-time buyers with lower price points; increased number of notebook PCs per person; and then thirdly potential substitution.

I think you already touched on this and you don't believe any substitution is happening, but the demand in those first two buckets, how would you split that out?

Paul Otellini, President and Chief Executive Officer

I wouldn't use your second category. It is not PCs per person, PCs per household. Many households are going from one PC to multiple PCs with these machines and that was some of the early purchases. Those purchases happened actually in the affluent cities or the tier 1 cities of some of the emerging market countries like China where it became a fashion item or machines for the kids.

I think that, who the heck knows, but my guess is that this year, year 1 of NetBooks, 80% to 90% of the volume will fall in those first two categories, and then maybe some substitution. In year 2 and year 3 I think it's just too soon to call. But our view is that these new price points, combined with a limited amount of features which is required to enable the price points, are likely to generate a new segment in the business.

Kevin Sellers, Vice President of Investor Relations

John, do you have a follow up?

John Barton, Cowen

I do. So if you think about the basic metrics of semiconductors, right, you've got the price lever, the computing performance lever and then the power consumption lever. I think what I just heard you say is a major catalyst for adoption of Atom is certainly the price at a reduced computing performance. How much has the computing performance limited adoption?

Paul Otellini, President and Chief Executive Officer

You know, this is sort of less than one-third of the performance of our Centrino. So you are dealing with something which most of us wouldn't use. You are dealing with something that is principally designed for net access, for web access, not really to run robust applications. I think it's likely to stay that way for quite some time.

As a comparative, you would not want to run YouTube video on these things all day long. You would not want to do any photo editing on these all day long, or even for a little bit of time. So I really think it's a first-time buyer kind of thing, and it will sort itself out. Just like there is a different market for lower priced, lower performing cars than higher end cars.

Stacy Smith, Chief Financial Officer

I think that is specific to the PC segment where Atom plays. When you get out into 2009 and it is playing in the broader segments you have the power characteristics of Atom are likely to be...

Paul Otellini, President and Chief Executive Officer

Into handheld.

Stacy Smith, Chief Financial Officer

Into the handheld business will be just as defining.

Operator

Your next question comes from Cody Acree, Stifel Nicolaus.

Cody Acree, Stifel Nicolaus

Back on the Atom acceptance, obviously coming in very strong. Can you talk, maybe Stacy, about the offsets of Atom's adoption, the curve of that pricing versus what you are seeing in the upside to 45-nanometer cost cuts?

Stacy Smith, Chief Financial Officer

Cody, I have to admit, I am not sure I understand your question.

Cody Acree, Stifel Nicolaus

You are getting an improvement to gross margins because of cost reductions coming down, the 45-nanometer ramp, Atom is coming up; it's got a lesser gross margin mix impact. How do those two offset each other, maybe as we look into the next few quarters?

Stacy Smith, Chief Financial Officer

The answer I have to give to that is they are in the 58% gross margin that I have forecasted for Q3. So even with the Atom ramp, yes that will bring costs down, it is likely to ship at a lower average selling price, but when I focus on the traditional, what I will call the microprocessor business without Atom, my costs come down in that segment of the business as well. So what I did is modify for you the overall costs. I think it's probably more on the traditional microprocessor business and less on Atom as we go across, at least the second half of this year.

Cody Acree, Stifel Nicolaus

And so even with the Atom adoption, even with the overall cost reductions, ASPs coming down, you are still well out-running those?

Stacy Smith, Chief Financial Officer

Let me say it a different way. If I didn't have Atom in the second half of the year, my costs would be coming down nicely. I see my factories are running pretty full, my 45-nanometer process is healthy, I am running good yields and product characteristics so my costs would be coming down even without the effect of Atom.

Cody Acree, Stifel Nicolaus

Lastly, I know that you said you would start to characterize as Atom starts to become more meaningful, just getting into a ramp. But Atom is getting a lot of attention here and will likely continue.

Can you characterize even weeks ahead, months ahead of where you thought you would be percentage ahead of where you thought you would be or when we might be able to get a little more data?

Paul Otellini, President and Chief Executive Officer

Well it depends on what point you start from. Versus last November we're 5X to 6X the volume for the year we thought; since a month ago we are 10% above it.

Cody Acree, Stifel Nicolaus

But versus maybe your expectations going into the quarter?

Stacy Smith, Chief Financial Officer

Going into the quarter, for Q2 it came in about as we expected. Remember, Q2 was the launch quarter for this thing, so it's just we knew how the builds ramped and that's pretty much what we sold. When you get into the Q3 again, as Paul said, it depends on what time period you choose. But I guess from the beginning of Q2, outlook in Q3 is probably 50% higher than we expected, something in that order.

Operator

Your next question comes from John Lau, Jefferies.

John Lau, Jefferies

Paul, in taking a step back, your guidance was very strong, especially in light of the uncertainty out there. Can you give us what the normal seasonality is, and more importantly. , whether that guidance is based on the feedback that you get?

How comfortable are you with the visibility this year versus the prior years, given the uncertainty? Thank you.

Paul Otellini, President and Chief Executive Officer

We're equally on the hook this year versus other years, so we're relatively comfortable – we are very comfortable with the guidance we have given out. Normal seasonality is about 9%, I think, Q2 to Q3 typically.

One of the things that gives me comfort is our chipset shipments in Q2. We said the chipsets were a record in Q2. Chipsets, as you may know, are a leading indicator of microprocessor or PC assembly. They get soldered on, they get purchased and then soldered onto motherboards multiple weeks ahead of the microprocessor, typically four to six weeks, depending on the vendor.

So the fact that we had very strong chipset shipments, record shipments and strong over the course of the quarter I think is a very good pointer for Q3, in addition to all the other data we have.

Stacy Smith, Chief Financial Officer

John, if I could just add to that. For Q2 we would typically see the second quarter down a couple of percent. If you strip out the impact of the NOR business divestiture, we were flat and for Q3, as Paul said, normal seasonality is 8.5% to 9%, in that kind of a range, and that's consistent with our outlook. The midpoint of our outlook is right in there.

Kevin Sellers, Vice President of Investor Relations

John, anything else?

John Lau, Jefferies

Can you just give us a quick schedule of the Larrabee, is that still on track with your expectations, and sampling at the end of this year> Is that how that's working out? Thank you.

Paul Otellini, President and Chief Executive Officer

Yes, Larrabee is on track. We haven't changed any schedules there.

Operator

Your next question comes from Srini Pajjuri, Merrill Lynch.

Srini Pajjuri, Merrill Lynch

Stacy, a couple of clarifications on the gross margin. First on the NAND side. What kind of an impact is NAND having on your gross margins now? If you were to exit NAND today, how will that impact your gross margin?

Stacy Smith, Chief Financial Officer

Gross margin would be higher.

Srini Pajjuri, Merrill Lynch

But by how much, is my question?

Stacy Smith, Chief Financial Officer

Sorry, that was tongue in cheek. As you know I think from prior calls, we don't break out that level of granularity. I will give you a little color commentary on what we saw on NAND in Q2 and what I expect over the course of the rest of this year.

The price environment continues to be weak NAND for us in Q2 came in as we expected. The gross margin impact didn't worsen from Q1, so it kind of stayed the same. We have costs coming down as the pricing comes down, which helps us.

And frankly, that is what I expect into the second half. I expect a continued weak pricing environment, but my costs come down nicely. I think it doesn't have either a positive or a negative effect on the overall corporate gross margin.

Srini Pajjuri, Merrill Lynch

My follow up is, I guess pretty much all of last year and earlier this year you saw a pretty good benefit from make ship to notebooks and now it seems like the notebook CPU pricing is probably closer or even below the pricing of the desktop CPUs. So my question is, are the margins still better in notebooks for you compared to your desktop segment?

Paul Otellini, President and Chief Executive Officer

The notebook prices are still nicely above the desktop prices, and I don't see them converging, frankly any time on the horizon, simply because there is a premium associated with the power performance characteristics on those product lines vis-à-vis the desktop.

So while they are coming down, I think we've said this in the last couple of calls, this is something we expect. It is a natural consequence of price volume expansion of the market. They are not moving to intercept desktop any time soon from our perspective. One of the ways that we're going to mitigate that is with Atom and NetBooks coming in, give us a much lower cost structure to be able to ride this curve then we did during the equivalent expansion of the desktop cycle five or six years ago.

Kevin Sellers, Vice President of Investor Relations

Thanks, Srini. Operator, we are going to take two more questioners, if you could?

Operator

Your next question comes from Michael Mcconnell, Pacific Crest Securities.

Michael Mcconnell, Pacific Crest Securities

Thank you. If we look at the gross margin guidance for the year, 57%, and the implied margins of 58% and then 60% in Q4, how much is built in, in those forecasts, that corporate adoption of Montevina will be healthy and the same level that we see with Santa Rosa?

Stacy Smith, Chief Financial Officer

If you are asking me, am I baking in an ASP increase to get there, that would be pretty unusual. The big drivers of gross margin as we go from Q2 to Q3 are, as I said, the costs coming down and the volume. I expect my costs to come down again in Q4 and volume to be up again in Q4. Those are really the drivers. I am not anticipating a mix shift to the high end or anything like that.

Michael Mcconnell, Pacific Crest Securities

Let me ask this another way, Stacy. If your mix on notebooks is similar to what you saw in Q2, can you still get to 57% for the year?

Stacy Smith, Chief Financial Officer

Sure.

Paul Otellini, President and Chief Executive Officer

In fact, I would expect notebooks will continue to grow as a percent of our output.

Stacy Smith, Chief Financial Officer

Yes.

Michael Mcconnell, Pacific Crest Securities

Paul, one last comment just on the healthy chipset strength you saw in Q2. Any comments on what you're seeing in Q3?

Paul Otellini, President and Chief Executive Officer

Nothing strange. Everything we see so far in terms of demand for chipsets is equally strong from the strength you saw in Q2. We will know a lot more three months from now when we see what the shipments are lining up for the fourth quarter, but right now in terms of the mix, particularly towards the newer chipsets, the demand is very strong.

Operator

Your last question comes from Brian Piccioni, BMO Capital Markets.

Brian Piccioni, BMO Capital Markets

Thank you for taking my question. Obviously Atom has been a lot of questions on this call. We mostly focused on the NetBook market for Atom. I am sort of curious, what do you expect the embedded market to be relative to NetBook sales?

As a follow-on, I am wondering if you have to make any ASP compromises for embedded applications?

Paul Otellini, President and Chief Executive Officer

Second part of the question is no. At this point in time the budgets that are being put out for embedded applications are in the same range as the desktop version, the higher power version of Atom that we are shipping in the PC space.

And that's because essentially they are being used as PC processors. Most of these things will run Windows and Linux. They are internet connections, general purpose reprogrammable machines, the embedded market is moving pretty rapidly in that direction.

In terms of the mix, gosh, that is hard to say. The problem is that, as you may know, the time from design win to production ramp with an embedded design, particularly some of these ones that are in regulated environments, can be one to two years. So if we add up all the designs wins, it is very strong.

I don't think that it would out ship the PC application, the PC uses, but I think it will be a very strong part of the product line.

Kevin Sellers, Vice President of Investor Relations

Thanks, Brian. Thank you all for joining the call today. As a reminder, our quiet period for the third quarter will begin at the close of business on August 29 and our third quarter earnings conference call is scheduled for Tuesday, October 14. Again, thank you all and good night.

Corporate Participants

Kevin Sellers, Vice President of Investor Relations
Paul Otellini, President and Chief Executive Officer
Stacy Smith, Chief Financial Officer

Analysts

John Pitzer, Credit Suisse
Tim Luke, Lehman Brothers
Glen Yeung, Citigroup
Ross Seymore, Deutsche Bank
James Covello, Goldman Sachs
Sumit Dhanda, Banc of America Securities
David Wong, Wachovia
Uche Orji, UBS
Chris Danely, JP Morgan
Hans Mosesmann, Raymond James
John Barton, Cowen
Cody Acree, Stifel Nicolaus
John Lau, Jefferies
Srini Pajjuri, Merrill Lynch
Michael Mcconnell, Pacific Crest Securities
Brian Piccioni, BMO Capital Markets