Share price of Advanced Micro Devices (NYSE:AMD) traded down 13.7% year to date, compared to a loss of only 1.8% for PHLX Semiconductor Index and 3.2% for S&P 500. Despite the recent weakness, the stock price has gone up by more than 50% from its 52-week low at $2.26 since April 2013 fueled by market's optimism on the company's gaming business. To me, the current hype is not sustainable and there could be a meaningful price downside. My view is supported by the following reasons.
AMD's Q4 results appear to support the market euphoria as the company reported above-expectation revenue and EPS which were driven by 29% sequential revenue growth for Graphics and Visual Solutions segment as a result of strong gaming console (i.e. Xbox One and PS4) sales. However, my view is that this result is not sustainable as the sales of gaming consoles are always strong in early cycle and the sales momentum will taper off as time progresses. Hence, I believe as similar growth level would hardly be seen in second half of 2014 and beyond.
On the other hand, AMD's PC business continued to suffer as evidenced by a sequential 9% decline in Q4 Computing revenue. In light of the secular declining trend, management indicated that the PC-related businesses could go down 10% in 2014. This is in contrast to many industry commentaries suggesting a stabilizing PC trend. Both Lenovo (OTCPK:LNVGY) and Hewlett Packard (NYSE:HPQ) recently reported better-than-expected PC sales primarily because Microsoft (NASDAQ:MSFT) will cease support for Windows XP in April 2014. Intel (NASDAQ:INTC) also echoed the trend by beating market expectation for its PC business and citing strength in consumer desktops. In a recent research note, Goldman Sachs estimated that AMD has lost over 3% market share to Intel in computing solutions since 2012. It is expected that AMD's PC business will continue to deteriorate and experience below-par performance as the company has stronger focus on low-end consumer PC, which is most vulnerable to cannibalizing from tablets.
On the profitability front, I am of the view that AMD's margins will be under pressure given the following developments:
- AMD's margin upside is likely to be limited by the fact that the sales momentum for Xbox One and PS4 could be near the peak, and thus incremental margin contribution from future gaming revenue may not offset the loss from the PC business.
- AMD derives royalty revenue from last generation gaming consoles for its technology being used in the devices. For the current generation consoles, OEMs start using chips supplied by AMD. As sales for the new consoles continue to grow and replace the old machines, the transition from licensing model to silicon model would drive down the company's profitability because margin on licensing revenue tends to be higher.
- Pricing for AMD's PC business will continue to be weighed by ongoing tablet growth and increasing competition from Intel as the rival continues to launch cost-effective products in the low-end PC market, where AMD is targeting.
The stock now trades at 0.65x trailing EV/Revenue multiple, which is notably above its 3-year historical low end range from 0.37x to 0.50x (see chart below).
My opinion is that a revenue multiple within the recent historical low end is more reasonable for AMD because 1) the company's PC business continues its secular decline and a recovery is unlikely; 2) AMD's margin has gone down from 7.2% in 2011 to 1.6% in 2013 and is likely to remain under pressure going forward; and 3) despite the recent sell-off, I believe the stock's current valuation still reflects some investors' optimism on the gaming business, which cannot be sustained. Based on a 0.50x trailing EV/Revenue multiple and assuming the company can meet the consensus revenue estimate of $5.7B for 2014, my 1-year target price would be $2.7 (assuming net debt remains unchanged), representing a 20% downside from the current level.
In summary, AMD is a sell at the current level as the company's primary business continues to underperform and there is a lack of sustainable turnaround plan, while the stock valuation is suggesting a much better prospect. Alternatively, investors may consider buying put options to profit from the trade.
All charts are created by the author except for the consensus estimate tables, which are sourced from S&P Capital IQ, and all financial data used in the article and the charts is sourced from S&P Capital IQ unless otherwise specified.