By Fred McClimans, John Freeman, Zach Mitchell
On 06 April 2017, Goldman Sachs initiated Advanced Micro Devices, Inc. (NASDAQ:AMD) at Sell with an $11 price target. The stock was sent into a tailspin, dropping to an intraday low of $12.86 before closing at $13.27 (-6.35% from its prior day close of $14.17).
Goldman’s justification is centered on its opinions that:
- AMD’s stronger fundamentals are already priced into the stock, and
- The presence of Intel (NASDAQ:INTC) and Nvidia (NASDAQ:NVDA) cap AMD’s market share potential.
Both arguments would be cause for concern if accurate. To Goldman’s first point, we agree that over the last several months, the market has gained a more optimistic view on AMD’s future – it is virtually impossible to argue otherwise, given the stock’s significant run up. But any claims that “improved execution” and “stronger fundamentals” are priced in to perfection are highly subjective and, further, are backwards-looking anyway. Such statements also do not give AMD due credit for its significant growth potential, and concerns related to Intel and Nvidia are overblown. The risks associated with a downward slide of AMD are, for these reasons, significantly less than the chances of upside potential (a point we’ll discuss below).
It’s also worth noting that Goldman’s $11 price target assumes a 12-month time horizon – interesting, but considerably less valuable than a longer-term (e.g., 5-year) time horizon given AMD’s growth potential.
Let’s understand the AMD model
In evaluating the long-term potential of AMD, it is important to understand its product cycles and how its revenue has been, and will be, generated. As noted in a recent post by Timothy Green, AMD’s success over the past couple of years has been driven almost entirely by its semi-custom chip business from both a revenue and operating-profit perspective.
Per AMD’s most recent 10-K filing, Sony Corporation, Microsoft Corporation and HP Inc. collectively accounted for approximately 59% of its consolidated net revenue for the year ended December 31, 2016. We believe the vast majority of this (excluding HP, which we estimate is 10%-15% of AMD’s total revenue) is derived primarily from its semi-custom business (essentially the PlayStation 4 and Xbox One products, which account for 86.4 million consoles since launch).
Moving forward, we expect this model to shift – gaming sales are likely to decline (as the products age, and the next gaming refresh cycle emerges), AMD’s PC CPU (Ryzen) sales seem poised to take off, and its upcoming server processor (Naples) and GPU processor (called VEGA) launches later this year will also contribute solid revenue streams. All three of these new products should place AMD in a position of action, rather than reaction – particularly against chief rival Intel in the PC and server segment and Nvidia in the GPU segment (note: we consider Nvidia to be in the strongest overall position of the three players).
AMD’s performance and pricing (below its competitors) makes it likely that Intel, and possibly Nvidia, may react with pricing discounts, but we’d rather see AMD in a position of driving that change than in a position of having to react. In this case, we anticipate any price-related issues to impact AMD later, rather than sooner. And in the case of the Vega GPU, we believe that the current growth of the GPU market, and extreme range of demand, will work in AMD’s favor.
In evaluating AMD, our investment thesis is based on the following core pillars:
- Improvements on the core platform: Continued evolution of its core products and a significant power/performance gain from AMD’s shift from a 28nm process to a 14nm process;
- Benefits from the rise of gaming: The cyclic refresh of gaming consoles leveraging AMD’s semi-custom chips and the emergence of increased performance requirements for VR and 4K support;
- Gross margin upside: The introduction of products that allow AMD to move its margins closer to Intel and Nvidia;
- Strong balance sheet: AMD has $1,264 in cash vs. just $1,435 in debt ($171 net); and
- Compelling valuation: While AMD has enjoyed a steady, and significant, run-up through 2016 and into the first quarter of 2017, we believe it still trades at a discount to Intel and Nvidia.
Our primary risks and concerns include the following:
- Track record: While the firm has performed well under Su, any missteps would likely be capitalized on aggressively by Intel and Nvidia;
- Secular declines: The ongoing decline of the PC market could cause additional revenue woes if it accelerates at even a slightly faster rate through 2017/2018; and
- Client concentration: Sony, Microsoft, and HP account for 59% of its revenue.
We believe that AMD, despite its recent advances, is still in the early innings of a turnaround. Over the last two years, the company has significantly improved its product portfolio across gaming GPUs, x86 CPUs (PCs and a re-entry to server), and gaming console products (semi-custom processors). We believe the recent investments in the products have positioned the company to regain modest share in both the PC and graphics markets and to benefit from upcoming 4K/VR-related gaming console refreshes.
Additionally, AMD has de-levered its balance sheet a bit with recent cash infusions from non-strategic business sales and IP license arrangements. We expect an ongoing reduction in debt to result in significant operating leverage as gross margins improve over the next few years.
Disclosure: We are long AMD