Smart Phone Threat

Paul Otelleni was getting ready to leave his position as CEO of Intel and turn over the reins to Brian Krzanich, who was currently Intel’s COO.1 Looking back, Otellini was proud of his accomplishments at Intel over the past eight years. Although revenue and the company’s stock price had been flat during Otelleni’s watch, shareholder dividends had grown at an average rate of over 13 percent, and he had positioned the company for the future by growing capital investments and research and development expenditures in the face of slower sales and stock price growth. Exhibit 1 displays Intel’s financial performance over Otelleni’s tenure.
The company’s biggest bets had come in diversification through acquisition; between 2005 and his retirement in 2013, the company purchased a dozen companies. By far the largest of these acquisitions was the 2011 purchase of McAfee for $7.68 billion.2 McAfee represented a huge gamble by Intel to enter the software security business, and whether Intel could create value through the purchase was an open question. Otelleni realized it may be the biggest challenge his successor would face as he tried to regain Intel’s leadership in a rapidly changing semiconductor business.

EXHIBIT 1 Intel Financial Performance, 2005–2012
Year 2005 2006 2007 2008 2009 2010 2011 2012 CAGR
Net Revenue ($ Billions) 38.8 35.4 38.3 37.6 35.1 43.6 54 53.3
Growth Rate −8.76% 8.19% −1.83% −6.65% 24.22% 23.85% −1.30% 4.05%
Earnings per Share ($) 1.4 0.86 1.18 0.92 0.77 2.01 2.39 2.13
Growth Rate −38.57% 37.21% −22.03% −16.30% 161.04% 18.91% −10.88% 5.39%
Dividends per Share Paid 0.32 0.4 0.45 0.55 0.56 0.63 0.78 0.87
Growth Rate 25.00% 12.50% 22.22% 1.82% 12.50% 23.81% 11.54% 13.32%
Capital Expenditures ($ Billions) 5.9 5.9 5 5.2 4.5 5.2 10.8 11
Growth Rate 0.00% −15.25% 4.00% −13.46% 15.56% 107.69% 1.85% 8.10%
Research and Development ($ Billions) 5.1 5.9 5.8 5.7 5.7 6.6 8.4 10.1
Growth Rate 15.69% −1.69% −1.72% 0.00% 15.79% 27.27% 20.24% 8.92%
Closing Stock Price ($, 01 July) 26.21 19.27 23.88 21.57 17.04 19.25 22.53 26.51
Growth Rate −26.48% 23.92% −9.67% −21.00% 12.97% 17.04% 17.67% 0.14%
Source: Intel Corporation, Annual Reports, 2008, 2012, stock price data from Intel Corporation.

1

A Changed Industry: The Rise of Arm-Powered Smart Devices
When Paul Otelleni became CEO of Intel, the company was the undisputed market leader in both the personal computer (PC) and server markets. The PC market had grown from 218 mil- lion units shipped in 2005 to almost 353 million units in 2012 (6.2% CAGR), but it represented a declining share of the overall computing device market. Yet, since Apple introduced its revolutionary iPhone in June of 2007, the market for “smart phones” had grown from almost nothing to 700 million units shipped in 2012 (a CAGR of over 126%)!3
Tablet computers had also displaced the traditional PC, with Apple’s iPad leading the way. Introduced in April of 2010, the iPad shipped over 3 million units in its first quarter. By the end of 2012, there were over 121 million iPads in use,4 and every major computer company introduced its own version of a tablet computer. Although Intel’s core market for PCs had grown at a respectable rate, in 2013, the PC market was widely considered to be an industry in long-term decline. Exhibit 2 shows projections for sales of different platforms of computing devices.
When Otelleni assumed command at Intel in 2005, the company enjoyed huge margins and, in spite of the cyclical nature of semiconductor sales industry, robust and profitable sales growth. Intel had almost no market share in the new market for smart phones and tablets, with sales barely reaching 1 percent of the mobile market in 2012.5 How had Intel missed the boat in this new industry? After all, Intel had created the microprocessor, the basic component that powers PCs, smart phones, and tablet computers. Since the introduction of the first chipset, the 4004 processor, Intel had relentlessly pursued a simple strategy: Obey Moore’s law, which states that every 18–24 months the number of transistors on a silicon chip doubles, dramatically increasing performance while halving the real cost of that performance.
Intel had followed Moore’s law, with the result being a product line of very powerful chips for a wide array of users. The Achilles heel in the Intel strategy could be found in the power usage of its chips. In the PC world of the 1980s to the 2000s, when PCs were all plugged into a

Growth in PC Market and Related Industries (all numbers in millions)
Device Type 2012 2013 2014 2017 CAGR
PC (Desktop & Notebook) 341,263 315,229 302,315 271,612 −3.73%
Ultramobile (e.g., Chromebook) 9,822 23,592 38,687 96,350 46.31%
Tablet 116,113 197,202 265,731 467,951 26.15%
Mobile Phone 1,746,176 1,875,774 1,949,722 2,128,871 3.36%
Total 2,215,386 2,413,810 2,558,469 2,966,801 4.99%

3,500,000

3,000,000

2,500,000

2,000,000

1,500,000

1,000,000

500,000

–

2012 2013 2014 2017

Mobile Phone Tablet
Ultramobile (e.g., Chromebook)
PC (Desktop & Notebook)

Source: Data from the Gartner Group.

wall socket, a power drain didn’t matter. Intel’s processors, the Core i7 line, introduced in 2008, had a thermal design power of between 95 and 150 watts.6 Thermal design power refers to the amount of power a computer’s cooling system requires to dissipate the heat generated by the microprocessor. In chasing increased processor performance, Intel had created a product line that consumed massive amounts of battery power. In contrast, Intel’s new competitor in the mobile space, ARM, had chips in use that required only 1.9 watts.
In a word, Intel had seen its growth potential disrupted.7 Mobile device users valued a sustainable “untethered experience,” the ability to use the device for long periods of time without draining the battery. In the power-rich world of PCs, performance mattered, and the greater the performance a chip could provide, the more intensive the software applications could be. Complex and sophisticated programs such as Microsoft Office ran very well on Intel’s high-performance chips. Mobile devices such as smart phones used very simple mobile apps and downloaded basic versions of websites and other Internet material. Performance, rather than being a competitive advantage, now became a disadvantage because unneeded capacity simply exhausted the battery more quickly.

Intel’s New Competitor: ARM
The company that would become ARM Holdings, PLC, began operations in 1979 as Acorn Computers, a company hoping to create—and cash in on—what it believed would be a huge demand for very low-priced personal computers.8 By 1981, the company produced a computer sold as a kit to be assembled by the end user. The kit sold for £40 (about $80).9 To reach such a low price point, Acorn designed all of its components in-house. Acorn won a contract with the British Broadcasting Corporation (BBC) to produce a new computer, the BBC Micro. The company assigned two engineers, Sophie Wilson and Steve Furber, to design a new microprocessor for the machine.
As a part of the design process, Wilson and Furber visited the Western Design Center in Phoenix, Arizona, a company that had been working on a similar chipset. They expected to find a large engineering center and fabrication facility. What they found was a very small operation and no production facility. As Furber later recalled, “A couple of senior engineers, and a bunch of college kids. . . . were designing this thing. We left that building utterly convinced that
designing processors was simple.”10 Furber and Wilson also realized that, to be profitable, a company did not need to incur all the expenses of production; licensing their designs to others and earning a nice royalty could be a path to profit.
Wilson did most of the design work for the new chip back in England. The new 32-bit chip, developed by 1984, used 25,000 transistors. By contrast, Intel’s 286 Chip, introduced in 1982, featured 134,000 transistors. The goal of the design process had been to produce a very inexpensive chip, so the team used plastic packaging, which meant the chip needed to have thermal resistance somewhere under 1 watt. When Wilson and Furber tested the chip, they had the surprise of their professional lives. The power meter they used to test the equipment didn’t even register: The pair had designed a chip that ran on no more than one-tenth of a watt! The Acorn chip was a simple chip that ran with very little power. Acorn Computers did not survive, but the chip would live on as the design team subsisted on design work for other chip manufacturers and small sales throughout the 1980s. In 1990, ARM incorporated, with Apple and VLSI (their fabrication partner) as the major investors in the new company.11 ARM’s big break came in 1993 when Apple decided to use its chip design in the Newton, the first personal digital assistant. Although the Apple device flopped (it was 5–10 years ahead of its time), ARM also had a toehold in the market, with contracts to power Samsung phones. The company also sold chips to Texas Instruments and became a fixture in the Nintendo DS hand- held gaming system in 2004.
ARM chips powered the Nokia 6110 phone, introduced in 1997. The phone featured several firsts. It was the first phone that worked on both analog and digital networks, the first phone to feature visual menu icons, and the first phone to include a game built in to the device.12

EXHIBIT 3 ARM Selected Financial Data
Year 2005 2006 2007 2008 2009 2010 2011 2012 CAGR
Net Revenue (£ Millions) 232.4 263.3 259.2 298.9 305 406.6 491.8 576.9
Growth Rate 13.30% −1.56% 15.32% 2.04% 33.31% 20.95% 17.30% 12.04%
Profit Before Tax (£ Millions) 40.5 56 45.1 63.2 47.2 110.1 156.9 221
Growth Rate 38.27% −19.46% 40.13% −25.32% 133.26% 42.51% 40.85% 23.63%
Dividends Paid (£ Millions) 10.4 12.4 18.5 26.4 29 34.3 42.2 51.8
Growth Rate 19.23% 49.19% 42.70% 9.85% 18.28% 23.03% 22.75% 22.23%
Capital Expenditures (£ Millions) 6.06 8.6 5.4 8.7 6.9 7.4 13 33.2
Growth Rate 41.91% −37.21% 61.11% −20.69% 7.25% 75.68% 155.38% 23.69%
Research and Development (£ Millions) 80.3 84.9 84 87.6 112.2 139.7 165.4 166.3
Growth Rate 5.73% −1.06% 4.29% 28.08% 24.51% 18.40% 0.54% 9.53%
Source: All data taken from ARM, Annual Report, 2008, 2012.

The Nokia phone ushered in the dawn of the smart phone era. ARM became the chip of choice for the emerging market and was a natural choice for the original Apple iPhone. By 2007, ARM chips would command 98 percent of the smart phone market, and in 2011, the company shipped over 8 billion chips.13 ARM took a radically different approach to the chip business than Intel. Intel essentially chose to vertically integrate chip production and to control the process from design through manufacture and on to marketing. ARM has always specialized in design work, and it invested £166 million in design activities for 2012. Following the lesson learned by Wilson and Furber, ARM licensed its chip designs to others for production. ARM focused solely on design and testing, avoiding the expense of building fabrication (fab) facilities. A new fab cost upwards of $5 billion in 2013, and ARM avoided the upfront costs, as well as the huge engineering and staffing costs. The company built a very strong and profitable business based on this model. Exhibit 3 shows financial data for 2005–2012.

Intel Responds
Intel found itself locked out of the smart phone market by 2007. The company did not sit idly by as it watched the industry migrate toward lower power chips and an Internet, software-centric consumer world. Intel responded to the ARM entry in two ways, through internal product development and acquisition.
Product Development. Intel recognized as early as 2004 the need to create a low-powered chip to compete in mobile devices.14 The new chip had to meet three difficult objectives for Intel: Low heat and power requirements that would facilitate use in mobile devices, low fabrication costs to produce a chip that would compete with ARM’s products, and compatibility with other Intel chips used in traditional PCs.15 The requirement for backward compatibility had been an organizational constant at Intel since the earliest days of the 80286 chipset; Intel believed that customers would be more likely to buy new Intel products as long as their current products would continue to work on the new platform.
The new chip, codenamed Silverthorne, had a head start when it began design. Intel had produced a lower-powered version of many of its chipsets, dating back to the 80386 in the mid- 1980s. Unfortunately, as the company moved beyond its original Pentium chip in the 1990s, low power usually meant stripping down the complex architecture of the chip. The chips used less power but ran very slowly. The new Silverthorne project built on the x86 chip architecture; how- ever, the ingrained habit of trying to maximize chip performance created its own momentum, producing chip “creep up” in terms of power usage.
In 2008, Intel introduced its Atom® line of chips to the market. The chips were close to ARM chips in power management; the Atom N200 used 2 watts, compared to ARM’s products that used 1.9 watts. The N200 retailed for $44, although customers could purchase a slightly more power-hungry 4-watt chip for $29. Because the Atom was built on the same architecture, or platform, as the Intel x86 line of chips (essentially everything in Intel’s line of PC processors from the early 1990s until the present), the Atom also fit into the Intel chip ecosystem. Customers had access to related processors and components from Intel, as well as Intel’s library of development software.16 Sales of the new processor showed early promise as notebook and ultralight device manufacturers adopted the product. Atom had a much harder time over- coming the industry’s emerging preference for ARM chips in order to penetrate the tablet and smart phone markets; the Atom chip had been adopted in only six smart phones by late 2012.17 Exhibit 4 provides data on quarterly sales of the Atom chipsets. The Atom seemed unlikely to capture a share of the critical markets of the early twenty-first century.
Acquisition. Between 2004 and 2012, Intel purchased 12 companies. Exhibit 5 provides details about these acquisitions. Many of these acquisitions had a specific goal in mind: to build Intel’s capability and presence in the software industry. The company had a long history in software, dating back to the original 4004 microprocessor introduced in 1970. Intel provided developers with a “blue box,” the SIM 4-01, of read-only memory that provided engineers with the software tools to program the chips for their particular application.18 Each generation of chip included its own basic programming instruction set, and Intel also provided software developers with compilers, instruction sets, and tools that allowed them to write applications for each new generation of chips. With the advent of Web 2.0 in the early 2000s, the need for advanced software capabilities grew. Web 2.0 was a series of software advances that allowed web page sponsors, such as companies, to provide users with a more dynamic experience. New features included secure product ordering and payment, video streaming, and rapid website customization (such as Amazon’s recommended reading list for customers based on their ear- lier purchases).
Intel found it quicker to purchase these new, dynamic software capabilities rather than develop them in-house. Intel began to branch out from producing the basic software that allowed programmers to write applications compatible with the x86 architecture. Intel also ran its own program for independent software developers and vendors. The company had

Atom CPU Sales ($ Millions)
500

EXHIBIT 4 Quarterly Sales of Atom Chipsets, 2008–2011
Source: Anton Shilov, “Intel Atom Technology Continues to Lose Popularity and PC Market,” Xbit laboratories
(January 20, 2012).

EXHIBIT 5 Intel’s Recent Acquisitions
Year Target Business
2004 Elbrus/Unipro Compilers (Russia)
2005 Sarvega XML code, engineers and IP
2007 Neoptica Visual recognition software
2007 Havok Computing game engine, middleware
2008 OpenedHand Linux User Interface, Mobile experience
2009 Offset Computing game visuals and middleware
2009 Wind River Embedded devices software
2009 Click Arts Parallel programming for multi-core processors
2010 Virtutech Virtualized systems development
2011 Nordic Edge Security solutions, identity management, authentication
2011 McAfee Security, spyware, virus protection
2011 Telmap Navigation and location services, search
Source: Caulfield, 2012.

trained over 20,000 vendor software engineers by 2012 to write for the Intel hardware platform. Intel pushed hard to create a set of software applications for supercomputers, very high-end and complex computers that ran the most sophisticated scientific programs, such as weather modeling and forecasting. Intel had also entered software markets targeted at end users. For example, the company had a team of engineers to support the development and diffusion of Linux, the public domain (free) operating system. Intel provided software packages and support to almost 3,000 schools and other educational institutions. By 2011, the company generated almost $2 billion in revenue from software sales, making Intel one of the 10 largest software vendors in the United States.19
Intel’s 2009 purchase of Wind River Systems exemplifies the company’s strategic thrust into software. Intel purchased the company in an all-cash deal valued at $884 million. The purchase price represented Intel’s largest acquisition in over a decade. Wind River writes software for “embedded devices”—electronic modules that function within larger machines. Embedded devices include many non-PC applications, such as smart phones, automobile entertainment systems, other consumer electronic goods, and a broad range of robots. Renee James, the Intel executive in charge of the software business at the time, said, “This acquisition will bring us complementary, market-leading software assets and an incredibly talented group of people to help us continue to grow our embedded systems and mobile device capabilities. Wind River has thousands of customers in a wide range of markets, and now both companies will be better positioned to meet growth opportunities in these areas.”20
Intel typically integrated acquisitions in one of three ways.21 A full acquisition meant that the acquired company would be absorbed into the larger Intel structure; all the operating elements of the business become fully integrated with existing Intel systems, reporting structures, and goals. The acquired company ceased to exist. In a partial, or hybrid, integration, Intel integrated certain components into the company—usually on the operational, or non- customer-facing “back-end.” The hybrid model allowed Intel to capture and develop things such as engineering talent, patented technologies, or important processes, while leveraging the existing brand and marketing abilities of the acquired company. Finally, Intel also managed acquisitions as a standalone business; the acquired company became a wholly owned subsidiary of Intel but did not integrate any systems with Intel.
When Intel purchased Wind River, 85 percent of the company’s business did not use Intel architectures, and Wind River customers were rightly concerned about the company’s commitment to their platforms. Intel chose to run Wind River as an independent, wholly owned subsidiary. Ken Klein, Wind River CEO, commented on the value of this arrangement: “We’ve been able to cement the level of trust that our customers and partners have in Wind River. Because we’ve been allowed to operate independently, we’ve been able to win over customers not only on Wind River, but I think [the acquisition] also helped to improve Intel’s reputation in the industry.”22
Intel hoped to create synergy in the future in three ways. First, by leveraging Wind River’s learning in the embedded and mobile device market, Intel hoped to better serve these markets with its other software and hardware offerings. Second, Intel believed that over time Wind River would migrate its software platform to the Intel architecture and bring Wind River’s customer base into the Intel family. Finally, Wind River was a large contributor to Linux; one motivation for the purchase was to leverage Wind River’s knowledge in Linux and other operating systems to develop superior products in the future.
Intel’s strategy of acquisitions had many critics. Some noted that Intel had gone on an acquisition spree in the early 1990s, and most of those acquisitions had failed, costing share- holders billions. Intel’s rich corporate culture often led to a “not invented here” (NIH) mentality; Intel engineers frequently failed to fully utilize superior hardware or software solutions just because they had been developed outside the company. Intel’s corporate culture of hard- driving excellence came at a steep price.23 As a hardware company, Intel lacked deep and expert technical knowledge in new areas, such as communications and networking chips.24 Some acquisitions just died on the vine. Other critics questioned Intel’s real commitment to acquisitions. Intel seemed comfortable in its dominant hardware business and often exhibited little tolerance for risk in new technologies and businesses. Acquisitions appeared to fill things in at the margin, without penetrating the Intel core.25 Finally, critics accused Intel of acting opportunistically but not strategically. The company often bought revenue, or it overpaid for intellectual property.26

The McAfee Acquisition
In August 2010, Intel announced the largest acquisition in its history, an all-cash deal to purchase software security maker McAfee for $7.68 billion. The deal closed in the first quarter of 2011. Like Wind River, McAfee would operate as an independent subsidiary. McAfee’s 2009 sales of $2 billion would add to Intel’s top line growth, but Intel intended to purchase more than just revenue or intellectual property. With its own acquisitions of Trust Digital and TenCube, McA- fee had a presence in the market for smart phone security software. Paul Otelleni stated the rational for the acquisition: Security represented “the third pillar of what people demand from all computing experiences” in the emerging mobile market. The other two pillars were energy- efficient devices and connectivity.27
McAfee enjoyed a colorful history. McAfee was founded in 1987 when software genius John McAfee brought an excellent security software package to market. McAfee sales skyrocketed in 1992 based on the fear of infection by the “Michelangelo” virus, a virus so deadly it would completely erase the hard drive of infected computers. Information about the Michelangelo virus originated with John McAfee, and the predicted computer calamity never occurred. The computing world would not see another panic like this one until Y2K doomsday scenarios appeared at the end of the decade.28 The incident illustrated McAfee’s unconventional views of appropriate business activity, and many customers denounced McAfee for creating a crisis just to sell software. In fact, McAfee had always run second to the much larger Symantec Corporation and its Norton Antivirus suite, a market position that would never change.
In spite of its unique founder, McAfee proved to be a reliable competitor. The company offered a suite of security products for consumer and business applications, had very high brand recognition, had a stable market share, and consistently owned just over 25 percent of industry sales. Symantec, under its Norton brand, commanded another 33 percent of the market; interestingly, software leader Microsoft had proven unable to penetrate the market and competed in fourth place, with less than 10 percent of the market.29 Symantec and McAfee

competed head to head in most markets, and neither competitor had the ability to deliver a knockout punch to the other.
For Intel, the McAfee acquisition presented two intriguing options. First, McAfee’s presence in all facets of software security, including mobile devices, provided Intel with another point of entry into the mobile market. The real prize for Intel, however, was the possibility of a game changer: the ability to encode security features directly onto a chip. The potential of hardware- encoded security would be huge: Customers would operate at a level of safety and security that would be much more difficult for hackers and others to penetrate; rather than merely exploiting gaps, or holes, that left software vulnerable, viruses would need to access the computer’s hardwired foundations. A hardware solution protects at a deeper level than the computer’s operating system, and a hardware-driven security platform offered the potential to root out, in real time, the most persistent and troublesome viruses.30
Of course, a hardware-based security system had never been created before, and it raised a number of questions:
• Could Intel and McAfee overcome the hurdles involved with creating a new security platform?
• Could two large companies, each with huge investments in their current business models and operations, overcome their corporate inertia and cultures to create such a product?
• Would the structure of the acquisition—keeping McAfee as a standalone unit of Intel—prevent the type of communication and knowledge sharing needed to develop new products?
• How would the market react? For example, updating software was a rather simple process for most consumers. What would the update path look like in a hardware-based world? Would customers need to purchase new chips rather than update?
• Why should Intel worry about security systems for mobile devices if it had almost no presence in this market?
• How would the acquisition affect the McAfee–Symantec competition? Would McAfee’s access to Intel technology and funding allow them to finally dominate this market? Conversely, would McAfee become so absorbed with Intel that it would fail to keep pace with Symantec?

Conclusion
In his last days as CEO of Intel, Paul Otelleni felt a sense of pride and relief: pride at what he had accomplished during his tenure in the CEO’s chair and relief that he would not have to face the new competitive environment in which Intel operated. He had inherited the world’s leading semiconductor company, one with an unmatched record for innovation and technological dominance. He had seen that dominance erode through the Great Recession of 2007–2009. However, the greatest challenges to Intel had come from the relentless “gale of destruction” that Joseph Schumpeter had written about a half century earlier.31 Those winds had blown Intel from an impregnable position to a very exposed one. Intel faced a set of nimble, talented, and well-funded competitors in the emerging markets for its products. Otelleni believed he had positioned the company to withstand the long-term trends in the industry and to eventually regain its dominance.

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