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Here's Why Intel Corporation's Data Center Group Operating Profit Dropped in 2016

A shot of a wafer of Intel server chips.

Microprocessor giant Intel (NASDAQ: INTC) reported a slight decline -- from $7.85 billion to $7.52 billion -- in the operating profit that its data center group (DCG) generated in 2016.

In Intel's freshly filed form 10-K, the company goes into significant detail about the major drivers behind this year-over-year operating profit decline. In this column, I'd like to go over those drivers and then talk about how, if at all, those same drivers could impact DCG's operating profit in the coming year.

The good news

A positive contributor to DCG operating profit, per Intel, was $930 million in additional gross margin because of an increase in platform (which Intel defines as processor and accompanying chipset) revenue.

A shot of a wafer of Intel server chips.

Image source: Intel.

In other words, sales went up, and since those sales carry a high gross profit margin percentage, total gross margin dollars clearly went up.

That, however, was it for the "good news."

The flood of bad news

Several items detracted from DCG's operating profit during 2016. Firstly, Intel reported $655 million in increased operating expenses year over year. Part of that almost certainly went to increased research and development expenses in support of future products and technologies, and part of that definitely went toward expanding the company's DCG-specific sales force by 20%.

Increased operating expenses hurt profitability in the near term, but the goal of such increased expenses is to have it pay off in the form of higher revenue growth down the line.

Beyond the increased operating expenses, Intel claimed a $335 million reduction in operating income due to "higher DCG platform unit costs." In the beginning of 2016, Intel started shifting its DCG products away from its mature 22-nanometer manufacturing technology toward its less mature 14-nanometer technology.

That shift ultimately ballooned the company's product cost structure, negatively impacting gross margin and, ultimately, operating margin.

Next, Intel says that it suffered a $215 million year-over-year decline in operating profit due to "period charges associated with product warranty and intellectual property agreements." Intel disclosed back on its most recent earnings call that it was having "product quality" issues one of its DCG product lines and that this represented the bulk of this $215 million hit.

The company didn't go into too much detail about the "intellectual property agreements" mentioned here, but the company did indicate that the impact of these were smaller than were the warranty issues.

And finally, Intel says that it saw a $52 million year-over-year hit to operating profit due to "other."

What this means for investors

Intel has said that it expects its DCG operating margin percentage to come down over the next four years due to a number of factors, which you can read about here .

For 2017 specifically, though, here's what I'm looking to see. Intel has guided to "high-single-digit" revenue growth in 2017, so -- barring a massive change in expectations here -- total gross profit should go up.

It's reasonable to expect that DCG operating expenses will rise again in 2017, as the company has made it clear that it continues to shift investments toward DCG. This will clearly be a headwind to overall profit growth.

Unlike in 2016, however, I don't expect 14-nanometer manufacturing costs to be a significant headwind. 14-nanometer manufacturing yields likely improved over the course of 2016 and I expect that they'll continue to do so over 2017.

The key thing to realize is that besides the improvements in 14-nanometer costs, Intel should also have an easier comparison -- from 2015 to 2016, Intel went from virtually no 14-nanometer server chip shipments to a lot of 14-nanometer chip shipments.

From 2016 to 2017, Intel will go from shipping a lot of chips on 14-nanometer to shifting even more of its product mix to 14-nanometer chips.

Intel has also made it clear that the warranty and intellectual property agreement charge isn't expected to repeat in 2017 (though it did come out of left field in 2016, so there's no ruling out something similarly unexpected happening in 2017).

All told, it's probably reasonable to expect total DCG operating profit to grow in 2017 relative to 2016 levels, though trying to pin down exactly what sort of operating margin percentage this business will ultimately generate this year is trickier.

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Ashraf Eassa owns shares of Intel. The Motley Fool recommends Intel. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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