This is not a $2.8 billion company; it is a $6 billion to $20 billion company. I'm writing about Advanced Micro Devices (NASDAQ:AMD). Based on the twelve trailing months operating margin, I need to see at least 1,500 basis points of operating margin expansion and at least another 100 basis point of net profit margin expansion. That plan should get the valuation into the $6 billion to $20 billion range.
Undesirable things happen sometimes. The debt-financed acquisition of ATI resulted in a goodwill writedown. The "financial crisis" occurred at the end of the decade. PC sales are slumping. I can understand those events resulting in a depressed equity valuation. That's fine.
But, I don't think it makes sense to continue to spend on operations like a growth company when revenue clearly isn't growing. It is with that in mind that I recommend reducing operating expenditure and decreasing leverage.
At this valuation, I'll make the equity investment and give management three to five years to increase the valuation to the $6 billion to $20 billion range.
A Path to Profitability
AMD has a relatively large debt footprint that stems from the ATI acquisition, the financial crisis, and PC sales. To increase the valuation of the common equity shares, AMD should reduce its total debt level. Instead of discussing the solvency ratios, I will model a change in the structure of the company's financial performance that should improve solvency and increase cash flows from operations and net income.
First, I need to examine the margins of the company and expenses as a percentage of revenue. AMD has a gross margin that is sub 50%; also, the company doesn't generate consistent operating profit. Below that is the interest expense which at this point is about $43 million per quarter, or roughly 3.75% of revenue.
Next, how can AMD increase its operating income? Well, research and development spending was 26.5% of revenue in the second calendar quarter. Also, sales, general, and administrative expenses were 14.7% of revenue. The research and development spending, as a percentage of revenue, seems high. To determine if it is high, I compared it to the R&D expenditure of other firms in the industry.
Intel spends roughly 20% of revenue on R&D, and Intel has a gross margin of roughly 60%. To make a long story short, AMD spends a large amount of revenue on R&D and SG&A considering its sub 50% gross margin. As another example, NVIDIA spends between 35% and 45% of it revenue on operating expenses, but NVIDIA has a gross margin above 50%. So, to increase operating profitability, AMD should increase the gross margin or decrease operating expenditure. I'm going to model a decrease in operating expenditure that would put AMD inline with industry comparisons.
Approximately how much money could AMD save by decreasing operating expenses? First, I think AMD should be spending somewhere between 15% and 30% of revenue on operating expenses. Using the twelve trailing months revenue and the mid-point of my operating expense range, the operating income would be $422 million including a lower than usual gross margin of 31.5%. Once the reduction of operating expenses is complete, AMD should use the available cash flow to reduce leverage and add at least 100 basis points to the net profit margin.
To make these cuts, management may need to focus the company more than it is currently focused in terms of product offerings, but alternative solutions may be available. The primary reason for the expense cuts is that R&D spending isn't generating a return: revenue is just above its 2003 level and operating profit is too inconsistent. I don't have all of the information that insiders have to make decisions, but based on the numbers, I think there should be a major restructuring of operations.
I'm going to use three scenarios to value the common equity shares. In all of these scenarios, I will use a price/sales multiple to value the company. There will be an adverse, baseline, and optimistic scenario.
In the adverse scenario, revenue declines to $2.5 billion annually because of the expense reductions and a profitable AMD is valued at one times sales. In this scenario, AMD would be valued at 11% less than it is currently valued, based on market capitalization.
In the baseline scenario, revenue is $4.6B and AMD is valued at two times sales. In this scenario, AMD is valued at $9.6 billion compared to the current $2.8 billion market capitalization. This alternative assumes no revenue growth and a valuation comparable to Intel's, NVIDIA's and Broadcom's current valuation.
In the optimistic scenario, AMD's revenue is $6 billion and the valuation is three times sales. The $18 billion valuation assumes revenue growth and a valuation above a current industry average valuation.
My model assumes a downside of about 10% and an enormous upside. But, it requires the successful execution of the operating expense and debt reduction plan. I will give the company 3 to 5 years to execute the plan.
The share price is starting a primary uptrend. Right now, AMD is trading in what could be an intermediate-term advance following an intermediate-term decline that seems to be part of a larger corrective wave. The technicals suggest being bullish with an initial trailing stop loss level of $3.10.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.