Why Intel Corporation's Research and Development Spending Surged Last Quarter

By Markets Fool.com

Back in April, microprocessor giant Intel (NASDAQ: INTC) announced a restructuring program designed to cut the company's operating expenses by $1.2 billion annually. As part of this program, Intel began pulling the plug on certain projects and laying off employees.

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However, the company told investors that even as it implements this restructuring program, it plans to "increase investments in the products and technologies that will fuel revenue growth, and drive more profitable mobile and [personal computer] businesses."

Image source: Intel.

Intel said that it "plans to increase investments in its data center, [Internet of Things], memory and connectivity businesses, as well as growing client segments such as 2-in-1s, gaming and home gateways."

Last quarter, Intel reported that its spending on research and development saw a 5% boost year-over-year -- amounting to a full $142 million in additional spending.

Let's take a closer look at what Intel says it's spending that extra money on.

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Straight from the chip giant's mouth

Intel said in its form 10-Q filing with the Securities and Exchange Commission that the year-over-year bump in research and development expenses was "driven by higher product and process development expenses and [programmable solutions group] expenses."

Partially offsetting that increase, the company said, was lower depreciation expenses "due to a change at the beginning of fiscal year 2016 to the estimated useful life of our machinery and equipment in our wafer fabrication facilities" as well as "savings from our 2016 restructuring program,"

Whew! If that seems a bit hard to understand, don't worry -- I'm going to break it down and explain each part in more detail.

The higher product expenses

In Intel's 10-Q filing, the company breaks down the key drivers of operating profit changes in each of its major business units.

In the table below, I show the year-over-year changes in operating expenses that Intel reported in several key business units:

Segment

Operating Expense Change

Client computing group

($285 million)

Data center group

$235 million

Internet of Things group

Up year over year

Programmable solutions group

Up year over year (this is a business unit that Intel formed late in 2015, and therefore did not contribute to operating expenses a year ago)

Non-volatile memory solutions

N/A

Data source: Intel 10-Q filing.

From this table, you can get a general sense of what is going on: Intel is investing more in its data center, Internet of Things, and programmable solutions (formerly Altera) groups. At the same time, Intel cut back expenses in its client computing group.

That's all in line with what Intel said it planned to do in its restructuring announcements -- invest in areas that have the potential to deliver solid revenue growth and cut back spending to maximize the profitability of segments with dimmer long-term growth prospects.

Higher process technology spending

You will recall that Intel said that it saw higher "process development expenses." Intel is likely referring to the costs associated with developing next-generation chip manufacturing technologies and enhancing current manufacturing technologies to wring more life out of them.

Considering how important chip manufacturing technology is and will continue to be to Intel's business, this is a sensible move. Frankly, considering the struggles that Intel has faced in bringing newer technologies to market, I would like to see even more aggressive investments here.

Lower depreciation costs

Intel said that, in addition to the cost reductions associated with its restructuring program, it is also seeing a benefit from the lengthening of the depreciation cycles of its chip manufacturing equipment.

To understand this, it's important to understand what depreciation is and how it can impact Intel's operating expenses.

When Intel buys equipment for its chip manufacturing facilities, it pays the full price of that equipment upfront. However, the full price of that equipment doesn't immediately show up in the company's cost of goods sold or in research and development.

Those costs are spread out, or depreciated, over a fixed amount of time. When Intel lengthened the amount of time that it expects to be able to use its chip manufacturing equipment, it increased the time it would take to depreciate a given piece of equipment, but the depreciation expenses that it would incur within any given period for that equipment would come down.

Now, it might seem strange to be talking about depreciation in the context of operating expenses. After all, shouldn't depreciation of equipment that's used to mass produce processors be included in cost of goods sold rather than in research and development spending?

Well, it's not so simple.

While the depreciation expenses of equipment used to build chips that ultimately get sold should be included in cost of goods sold, the development of next-generation chip manufacturing technologies also requires the use of a lot of very expensive equipment.

Workers inside of an Intel development fab. Image source: Intel.

In fact, Intel has chip manufacturing plants dedicated solely to the development of next-generation chip manufacturing technologies (Intel calls them "development fabs"). The equipment inside of those factories also needs to be depreciated, just as the equipment inside of the factories that are pumping out salable product does.

If the depreciation schedules for that equipment also lengthens, then that should lower Intel's research and development expenses, all else being the same.

Looking ahead

It's clear that Intel is still investing heavily in its future, even after the significant restructuring actions that it announced. Developing leading new technologies for Intel's current markets and trying to push into new ones simply isn't cheap.

Those hoping for Intel to significantly bring down its operating cost structure longer-term are likely going to be disappointed. The good news is that if Intel's investments allow it to accelerate its revenue growth rate (its revenue growth over the last several years has been anemic at best), then that could be good for the business and the stock price in the long term.

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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.