Advanced Micro Devices (NASDAQ:AMD) is one of the biggest microprocessor manufacturers in the world, behind only Intel (NASDAQ:INTC). The stock was trading over $42 in 2006 - however, since then, the stock has been in steep decline and currently trades close to $3.65. The technology sector is extremely volatile and ever changing trends in the sector have deep impact on its participants. The best way to meet these volatile trends is a substantial investment in R&D and a flexible strategy. AMD had to make a shift in strategy to turnaround the company from one of the worst situations in its history. We are now seeing the benefits of the change in the strategy as the stock is making impressive recovery. In this article, I have tried to determine the fair value of the stock based on future free cash flows. The free cash flows model uses certain assumptions which I will explain in the following paragraphs.
The model includes assumptions about revenue growth, cost of sales, operating expenses, non-cash charges and research and development. Let's take a look at these one by one.
- Revenue: Assumptions about revenue growth are the most important as revenues are the starting point of our model. Over the past three years, AMD has been facing declining revenue, and it looks like the current year will also end with lower total revenue (total revenue for nine months ended in September was $3,710 million) than the last year. However, revenue growth in future will pick up in my opinion, mainly because of the shift from the PCs business. Graphics and visual segment have recorded massive growth - however, it should be kept in mind that majority of the company's revenue still comes from PCs segment, which is not showing any signs of growth. As a result, I have assumed revenue growth rate of 5% for 2014 and 2015 (I would have assumed a higher growth rate if the size of the PCs segment in its total revenue were smaller). However, revenue growth in the next four years will remain at 7% due to the decrease in PCs segment, and finally, the growth rate will decline to settle on 3% terminal rate. I believe my growth assumptions are conservative as the company has come up with some new products, which will boost sales in the short-term as well as long-term. All the major gaming consoles are using AMD processors, Kaveri will be in the market in next month, and the strategy to balance the revenue is mix working well.
- Cost of Sales: Historically, cost of sales for AMD has been around 55% -- however, during the last year it reached 77%. Cost of sales for the first three quarters has been close to 62%; for the whole year, I have assumed it to be 62%, as we do not have the results of the final quarter yet. For future I have assumed declining cost of sales due to economies of scale and better deals, and it will settle at 54% in the fifth year of the valuation model. The company can very well decrease the cost of sales in earlier years by working on better supplier deals and production process, which will result in higher operating margin and possibly higher valuation.
- Research and Development: It is an important expense for a company operating in the technology sector. AMD has been spending about 22% of its revenues on R&D expenses. For the first three quarter is the year, this expense stands at 24.4% of total revenues - as a result, I have kept the percentage constant for the year, and total expense for 2013 is assumed to be 24.4% of total revenues. In the following years, I have increased the R&D expense to be 25% of the total revenues as I believe the company will have to maintain a high R&D expenditure in order to continue growth.
- Marketing, General, and Administrative Expenses: These expenses are currently around 15% of the total revenues, and I have kept this expense constant at 15% for the whole model.
- Taxes: Taxes are a tricky component of the AMD books. The company has been incurring losses and as a result, it has accumulated some tax benefit. At the moment, deferred tax assets of the company stand at $17 million and it has a hefty deferred tax liability and valuation allowance. In each of the previous two years, the company has reported a tax benefit. However, in 2010, the effective tax rate for AMD was 3.49%. It is extremely difficult to predict a tax liability as it is heavily dependent on when the company will turn in enough income to off-set that liability. For the sake of simplicity, I have kept the tax rate at 7% for the model.
The following table shows the Pro-Forma earnings of the company.
Under the current assumptions, the company will turn profitable in 2015, and the growth in earnings will remain strong in the following years.
For the valuation part, there are some further assumptions regarding the discount rate, additional investment in fixed and working capital and adjustments for non-cash items. Our discount rate is 10%, which I believe is appropriate based on the capital structure of the company. However, discount rate may vary for every investor based on the perceived risk of the security. Below table shows free cash flows and valuation.
For the free cash flow calculation, I have taken net income as the starting point. All of these net income figures represent projected net income based on above mentioned assumptions. To reach at free cash flows, I have made adjustments regarding, amortization and other non-cash items such as gains/losses on equipment sale and taxes. Furthermore, investment in fixed and working capital has also been taken into account. Non-cash items include depreciation and amortization along with stock based compensation - these items are added back to net income.
However, investment in fixed capital and working capital has been deducted from the net income to reach at the free cash flows. Free cash flows beyond 2022 have been projected at a constant growth rate of 3% and discounted at the discount rate of 10% (adjusted for growth rate) to calculate terminal year free cash flows. After calculating free cash flows for each year, I have discounted those free cash flows at 10% to reach at the present value, and added them to achieve about $3.42 billion in discounted free cash flows. According to my free cash flow model, AMD should be trading at around $4.52 per share. At the moment, the stock is trading at around $3.65 per share.
AMD is certainly on the way to recovery - however, the company is not completely out of danger. There is intense competition in the industry, and shareholder should not expect miracles in the short-term. However, I see potential in the company and believe the long-term prospects are good. According to my calculations, the stock is undervalued at the moment, and substantial upside potential exists in AMD. The results of the model with stricter assumptions were $3.90 per share and $6.44 with a little generous assumptions.
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.