Intel's Data Center Business Is Struggling

Given how strongly the major cloud computing companies are growing, it's a little surprising how poorlyIntel's(INTC-8.56%)data center business performed during the second quarter.

Intel's enterprise customer base is far broader than cloud computing providers, and recession fears are starting to impact purchasing and expansion decisions at businesses. But the company wasn't even in the ballpark of expectations.

Unexpected weakness

Intel's data center and artificial-intelligence (AI) segment produced $4.65 billion of revenue in the second quarter, down 16% year over year. Analyst Vivek Arya ofBank of America(BAC1.47%)Merrill Lynch pointed outduring the earnings callthat this performance was close to 25% below expectations, which was likely a big reason the stock had dropped around 9% by Friday afternoon.

There were multiple factors that knocked down Intel's highly profitable data center business. First, just like what's happening in the PC market, Intel's data center customers are adjusting their inventory levels to better reflect current market conditions. Companies that sell servers don't want to hold so much component inventory in the face of uncertain demand, and customers that use Intel's data center chips for their own data centers might be adjusting their upgrade and expansion plans as the economy weakens.

Second, Intel is having some trouble getting its hands on components it needs, including Ethernet and power supply components. Supply chain constraints are still hampering thesemiconductor industry, although a drop in demand could go a long way toward fixing that problem.

Lastly, Intel admitted to some execution problems with its Sapphire Rapids data center CPUs. An additional stepping, essentially a design change, was done on the product line as the company aims to keep "the quality bar high," according to CEO Pat Gelsinger. Production of the main Sapphire Rapids CPUs won't be ramping up until the end of this year and into next year, pushing back some revenue.

For the full year, Intel has lowered its expectations for its server-related total addressable market to reflect slower growth. The company also expects to grow more slowly than the overall data center market as it rebuilds its product portfolio. Intel is the market leader, but it's facing pressure from competitive products from rivalAdvanced Micro Devices(AMD3.05%).

Why a turnaround is so important

Intel's data center business is a cash cow, or at least it was. In 2020, for example, the data center segment produced operating income of $10.6 billion on $26.1 billion of revenue. That's an operating margin of about 40%.

The headwinds Intel is facing in the data center business caused operating profits to plunge in the second quarter. The segment produced operating income of just $214 million, down from $2.1 billion in the same period last year. That 90% decline was due to a host of factors, including start-up costs for advanced manufacturing nodes, investments in the product road map, and charges related to the pre-production of Sapphire Rapids CPUs.

Intel is optimistic that Sapphire Rapids will be a successful product line, but Gelsinger admitted during the earnings call that the company's execution around it hasn't been its "finest hour" in execution, adding, "We're rebuilding our execution machine."

Intel expects its data-center market opportunity to grow by at least a mid-teens percentage annually in the long run. Sapphire Rapids, as well as ancillary products like its Arctic Sound-M data center GPU, will help it tap into that growth once it gets its ducks in a row.$Intel(INTC)$