Advanced Micro Devices (AMD) reported its fourth quarter earnings after the bell on 1/22. The results weren't expected to be particularly good, especially as the firm's financial and competitive woes are certainly not a secret on Wall Street. After studying the earnings release and listening to the earnings call, I believe that there is quite a lot to say about the AMD turnaround story. Is the worst of it over, or should investors expect continued pain as the company continues to try to find its feet?
There were a number of positives that stood out in the report:
- Non-GAAP gross margin (i.e. margin after taking a $320M charge in order to get out of a wafer commitment) was 39% in the quarter, a sequential increase of 8%.
- Operating costs continue to come down as part of the restructuring effort, and the company seems on track to hit the $450M/quarter opex run rate by Q3 2013 (at which time the company actually expects to be cash-flow positive)
- Microprocessor ASPs were up sequentially
- The company's cash balance stood at $1.2B, which is safely above the firm's "optimal" zone of $1.1B and very much above the $700M minimum needed for non-interrupted operation. The company expects to stay at or above the "optimal" zone throughout 2013
- Server revenues saw a sequential increase
- Q/Q graphics segment operation profit was up $4M from the prior quarter, even on a lower revenue base. The company also noted record revenue in workstation graphics
- Desktop ASP was up (due to the launch of the refresh of its "FX" processors)
- One third of laptops sold in US retail during the holiday season were powered by AMD APUs
Here were the negatives that stood out in the report:
- Mobile (laptop) ASPs were down, likely as the competitive positioning in this space against Intel's (INTC) "Ivy Bridge" is particularly weak
- Graphics revenue was down 5% sequentially, and down 15% year over year, implying continued market share loss to its primary rival, Nvidia (NVDA) (although management implied that the share bleeding should stop with the introduction of new products)
- GAAP Gross margin was a mere 15%. While this includes the effects of the take-or-pay charge, these kinds of "one time charges" are fairly common
- The server increase was primarily driven by the sale of entire systems via the firm's SeaMicro division. These likely contributed minimally to actual CPU revenues and, in fact, served to drive volume for competitor Intel, whose CPUs power the vast majority of these machines (AMD has begun shipping its own silicon into these things, but it is unclear which systems the customers will ultimately want)
- Sales were down 17% Y/Y for the full year, and the revenue attrition accelerated in Q4 with a 32% Y/Y decline
- Company saw a full year net loss of $1.18B or $1.60/share
With that recap, I will now go into a little more detail on my thoughts on the turnaround.
Can The Turnaround Succeed?
AMD's major problems are the following:
- The PC space in general (from which 80-85% of revenues are derived) is in a secular slump
- The company faces a very fierce competitor in the PC space in Intel. The company not only has numerous technological advantages, but executional and marketing ones as well. Intel will continue to out-execute AMD in the PC space as its tablet/phone/datacenter initiatives continue to play out
- Nvidia is proving to be an exceptionally tough competitor in the graphics space, AMD's only operationally profitable market segment
The turnaround play that AMD is attempting to execute hinges on the following strategy:
- Traditional PC sales become ~40-50% of revenues, and new opportunities (cloud servers, tablets, embedded) comprise the remainder
- In these new segments that may not be so performance sensitive but instead require design/integration flexbility, a move to commodity processes, automated design, and other time to market/cost saving initiatives will allow for a meaningful reduction in opex
- In these new segments, AMD's combination of graphics and X86 CPU expertise, coupled with new talent to focus on SoC designs, should prove to be fairly strong competitive advantage
I am hopeful that AMD can actually execute the turnaround and become a profitable, growing business. It is not clear at this moment that this will succeed, but I will say that as a speculative turnaround play, there could be some real value here for investors with a high risk tolerance.
Relative Valuation Gives Post-Turnaround Target
As it stands, AMD is a CPU/SoC + GPU design company, so the nearest comparable business is Nvidia. As it stands, Nvidia's enterprise value is $4.19B (this is market cap less cash) and generated $420M in free-cash-flow over the last twelve months. While AMD and Nvidia differ in a number of areas (Nvidia has a modem/baseband strategy which allows it to compete in the phones, and it has a proven tablet strategy), I believe that a reasonable upper bound on AMD's price over the next 12 months can be constructed by setting its enterprise value -- in the case that the turnaround shows a high probability of success -- equal to Nvidia's.
At a market capitalization of $1.74B, and given the net debt position of $904M, the company's EV comes out to $2.64B. An EV of ~$4B would imply a market capitalization of $3.1B, or a price of $4.2/share.
I believe, however, this price target is exceedingly optimistic, especially given the significant financial strength and cash generating abilities of Nvidia, but should the stars align for AMD over the next 12 months, this is where I believe an upper bound on the valuation should be. I note that Nvidia's valuation is somewhat depressed, especially as the Street is not confident that its mobile strategy will play out. While I expect Nvidia to be worth significantly more over the next 12 months, I would be hesitant to move the bar up for AMD in the event that Nvidia becomes more fully valued.
While I remain skeptical that AMD will return to a cash flow positive state in 2H 2013, especially in light of the fact that the company refuses to give full year revenue or gross margin guidance, I will take some liberties and construct the following model:
- I expect CY2013 revenues of $4.7B (Q1 and Q2 at $1.05B each, Q3 and Q4 at $1.3B -- breakeven level)
- Gross margin of 40%
- Opex of $1.9B during CY2013
From this baseline, I would then model the following positive scenario:
- 10% revenue growth from CY2013 -> CY2014, assuming the new initiatives (embedded, especially game consoles, in addition to success of Kabini/Temash and SeaMicro initiatives)
- Opex at $450M/qtr run rate
- Gross margins of 42%
- $371M in operating income
- Assume 25% tax rate, and assume quarterly interest expenses of $45M
- Using 747M shares, this gives us EPS of ~$0.13
- Applying a fairly liberal 25x multiple (not uncommon for "turnarounds" that have just become profitable again), a target price of $3.25 is reached.
Of course, there is significant risk to this model, and as such, I do not recommend buying shares unless you are willing to accept that, while bankruptcy is not likely a near-term concern, execution issues are very much in line with the company's history. In addition, strong competitive pressures in the markets that AMD is gunning for (especially from Intel and Nvidia), coupled with the risk that the R&D cuts have simply gone "too deep", also serve as significant headwinds to competitiveness in the future.