The AMD Story Sounds Very Familiar

By Stephen D. Simpson, CFA | July 22, 2013 AAA

There is a group of tech companies out there whose greatest accomplishment is simply staying in business over the span of decades. Advanced Micro Devices (NYSE:AMD) is a good example, as this company has a horrible record when it comes to generating cash flow or building/maintaining market share, but still seems to get investors re-excited about its prospects every so often. With no reason to believe that AMD will regain share in PCs, build share in tablets or microservers, or achieve any meaningful sustained cash flow from consoles, I see no reason to own AMD shares at this point.

Second Quarter Earnings Highlight Some Of The Trouble
AMD's second quarter results are part of the reason that I'm not all that optimistic about the company's fortunes. Revenue declined 18% from last year, but rose 7% sequentially. Computing revenue declined 20% from last year and rose 12% sequentially, while graphics revenue was down 13% and 5% respectively.

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I'm not surprised to see that margins declined on a year-on-year basis, but the lack of sequential gross margin improvement on higher revenue is a concern. Gross margin declined six points from last year and more than a point sequentially, while the company logged another operating loss.

Some Share Growth, For What It Matters
That 12% sequential increase in the computing business is interesting given the sluggish (very low single digit increase) performance at Intel (Nasdaq: INTC) this quarter. But perspective is important – while it does seem that AMD gained a couple of points of PC processor share from the first to the second quarter, the company's share is still in the low teens – well below the brief glory days in 2006 when the company's share was into the 20%'s.

The problem is, though, that I just don't see where AMD fits in anymore. Intel is ahead of AMD in every way that matters – performance, price, R&D, manufacturing – that I don't see how AMD is ever anything more than just a tagalong. Likewise, I see no reason to believe that AMD has a future in tablets or other mobile devices – they don't have the capabilities to compete on the high end, and I see no reason why Spreadtrum or MediaTek wouldn't chew them up on the lower end.

I likewise have little-to-no faith in AMD in graphics or microservers. Nvidia's (Nasdaq: NVDA) capabilities have pushed AMD's share down to about one-third of the market, and I see nothing in the price/performance of new AMD products to think that the company will claw back a meaningful amount of share. On the microserver side, I not only think that the bulls are overestimating the opportunity for this as a product category, but overestimating the likelihood of AMD establishing a sustainable business against Applied Micro (Nasdaq: AMCC), Broadcom (Nasdaq: BRCM), Marvell (Nasdaq: MRVL) and others.

What About Consoles?
It seems that the bull story on AMD hinges around the aforementioned microservers and new console wins with Microsoft (Nasdaq: MSFT) and Sony (NYSE: SNE) for their next-gen gaming systems. Here again, though, I think bulls are too optimistic that “this time is different”.

AMD will likely generate a per-chip price around $80 overall (more from Sony, less from Microsoft), but already management has talked down profit expectations. Bullish sell-side analysts boldly predicted gross margins in the 30%'s and operating margins in the 20%'s, only to be told that GMs will likely be closer to 20% (or below) and operating margins will be in the low double-digits.

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While AMD doesn't have to worry about competition for these sockets, I don't see where AMD has established the credibility to suggest that they will garner substantial free cash flows from this business. All told, I believe these console wins will be worth about $1.00 to $2.00 per share to AMD on a discounted cash flow basis, but it's worth remembering that each incremental 1% of operating margin on this business may only be worth about $0.01 or $0.02 per share.

The Bottom Line
I'm sure I'll hear the usual litany of “You're secretly short/hedge funds are paying you to write this” nonsense from angry longs. What I'd really like to hear, though, is the counter-argument. Where is the evidence that AMD can do much of anything right? The company has shown no ability to compete with Intel or Nvidia on a sustained basis, and the company has been free cash flow positive exactly twice in ten years – a time during which Nvidia has grown from about $1.8 billion in revenue to $4.3 billion in revenue and just under $800 million in trailing free cash flow.

For now, I'm looking for long-term revenue growth of about 5% and sustained free cash flow margins in the mid single digits. Given AMD's history, predicting any level of sustained positive free cash flow is bullish, but those forecasts are only worth about $3.25 in fair value. Go to a 10% free cash flow margin in 2022 and you can get a target north of $5.50, but it seems like there's already a strong hope trade in these shares.

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