Why Intel Corp.s Internet of Things Business Slowed Down

By Markets Fool.com

Image credit: Intel.

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A small-but-interesting business segment for microprocessor giant Intel (NASDAQ: INTC) is its Internet of Things business. According to the company, this segment sells platforms aimed at "retail, transportation, industrial, and buildings and home use, along with a broad range of other market segments."

In 2015, IoT offerings brought in $2.3 billion in revenue and $515 million in operating income for the chip giant. Although that's relatively minor compared to its $32 billion client computing group, or even its $16 billion data center group, or DCG, this is a growth business, and a solidly profitable one at that.

Interestingly, after this segment delivered 22% year-over-year growth during the first quarter of the year, the growth pace slowed significantly in the second quarter, coming in at just 2%.

Let's take a closer look to see what's going on here.

Missing expectations due to "inventory burn"

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In his prepared remarks on the earnings call, CEO Brian Krzanich said these results were worse than the company had expected.

"We saw growth in the industrial and video verticals, offset by an inventory burn after a very strong first quarter," he explained.

CFO Stacy Smith chimed in later to further clarify that this inventory burn had resulted from the company's customers getting "a little ahead of their skis in the first quarter." He did, however, say that the company expects this business to see a "reacceleration" during the second half of 2016.

"I had said at the investor meeting that we expect double-digit growth in excess of what we had achieved last year," Smith reminded investors. "We still expect that."

How's profitability look?

In the first quarter, Intel's IoT business saw operating profit rise to $123 million, from $87 million in the year prior. This quarter, things didn't look so hot.

Operating income fell to $89 million, down significantly both from the prior quarter and from the year-ago quarter's $145 million. I don't think that Intel is suffering from gross profit margin compression here; instead, it's being hit by a loss of operating leverage. The company has likely increased its research and development spending on IoT year over year, so when revenue doesn't grow as much as planned, operating income suffers.

We'll see if Intel hits its target

Intel management seems confident that this segment will rebound in the second half of the year and deliver robust year-over-year growth. That said, even if the company falls short of expectations in this business, it's just not all that large a part of its overall revenue or operating income.

Someday this business may be large enough to move the needle for the company, but today it's not a big deal. Intel's longer-term focus should be to invest in the right products and opportunities so that, at some point in the future, this segment can become a large contributor to the company's consolidated revenue base.

It could be a while, but if Intel succeeds in building this business up, long-term investors should be nicely rewarded.

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Ashraf Eassa owns shares of Intel. The Motley Fool recommends Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.