AMD (AMD) has come back from the brink after a terrible year in 2012, where it lost over $1 billion. It has a new CEO, Rory Read, and a new strategy to make it less dependent on the crumbling PC market. This strategy is to concentrate on designing chips for other manufacturers to sell rather than selling them directly to OEMs as it does with PC chips and graphics cards. So far this "semi custom" strategy seems to be paying off with AMD winning the CPU and GPU contracts for the next generation consoles from Microsoft (MSFT) and Sony (SNE).
However, AMD is still barely profitable; it only managed to record a profit for the latest quarter of $48 million. Expectations are for profits to increase going forward as sales of new consoles ramp, but much depends on the state of the PC market as well as AMD's micro server efforts paying off.
It's AMD's balance sheet that is the real cause of concern as it has about $4 billion of liabilities only offset by around $3 billion in current assets, including inventory. In my view there's still a quite serious risk that AMD will end up needing to raise further capital. To demonstrate just how vulnerable AMD is, I'm actually going to use a financial analysis technique called the Z Altman score, which is a tool to determine the chance that a company will go bankrupt within the next couple of years. This is an empirical formula that has proven to be highly accurate.
Now, I'm not suggesting that AMD will actually go bankrupt. I don't think it will be allowed to for a start, as that would leave Intel (INTC) with the only X86 licenses. But there might have to be either a forced sale to someone like Qualcomm (QCOM), a debt for equity restructuring, or just plain new share issuance, to bolster the balance sheet. In such scenarios, AMD's stock could easily fall back to the $2 level or perhaps even below that.
So what is AMD's current Z Altman score? The score is calculated using various factors from a company's balance and income statements.
Z = 1.2A + 1.4B + 3.3C + .6D + E, where
A = Working Capital/Total Assets
B = Retained Earnings/Total Assets
C = EBIT/Total Assets
D = Market Cap/Total Liabilities
E = Sales/Total Assets
Using the latest quarter's figures, annualized, AMD's Z Altman score is 1.2X.28 +1.4X (-1.4) +3.3X.08 +.6X.64 +1.4 = .43.
How bad is that? Well above 3 a company is considered safe, between 1.8 and 3 there is some doubt about the future of a company, and below 1.8 the company is predicted to have a high chance of bankruptcy within a few years. So pretty bad then.
One can obviously query specific terms and also substitute higher EBIT figures going forward, as well as higher sales and better retained earnings, which is the biggest negative factor at the moment. On the other hand I've used the latest quarter's EBIT figures and then annualized them rather than using the full year figures which were much worse - a $1 billion loss.
AMD will struggle to hold its own against Nvidia (NVDA) in discrete graphics cards and Intel and others in servers. That leaves only semi custom - video game console chips, essentially - as the only uncontested growth area, to replace declining PC sales.
The question is how much demand is there for these next generation video game consoles? Initially, there's likely to be a lot of pent up demand since it's been 8 years since launch of the previous models, so the end of 2013 - the next quarter - and 2014 should be good for AMD. Will there continue to be buyers beyond that time? Here are a few things to bear in mind about the new consoles:
1. There are diminishing returns to better graphics and improved resolutions. The original PlayStation was from the first generation of 3D videogame consoles; all subsequent models only offered incremental improvements. The only possible exception to that trend was the PlayStation 3, which came out around the time that HD LCD TVs were taking off, and those televisions helped deliver a more significant boost to the viewing experience.
2. Since all the new videogame consoles run on x86 chips, none of the games from the previous models will play on the Xbox One or PS4. This is unlike the PS3, which could play all the games for the PS2 and the Xbox 360, which could play most of the games from the original Xbox. Thus a prospective buyer of the new consoles, who doesn't already own any existing videogame console, will be faced with the choice of paying $400 or $500 for a new generation console or paying perhaps half that (second hand or discounted) for a Xbox 360 or PS3 and accessing a much larger catalog of games.
3. The state of gaming has changed since the launch of the previous generation of machines. Facebook games and mobile games on smartphones and tablets, mean that for the same money as a console someone can get an iPad Air, which first of all, gets them a device that can do a lot more than just play games, and secondly where the games cost at most $15 instead of $60 (plus a $60 annual subscription fee if you want to play any of the popular games).
AMD is currently selling for 25 X consensus earnings estimates for 2014, and remember that will be a year when AMD can bank good video console sales. This seems far too pricey. $2 per share, which is where AMD traded at the lows of last year, would result in a far more reasonable 15 P/E ratio.
AMD is still a very financially vulnerable company, where any number of catalysts might serve to bring this company to its knees, including greater than expected weakness in the PC market, making no headway in the competitive micro server segment or a less than enthusiastic interest in the new video game consoles from Sony and Microsoft.