- The bull thesis on AMD centers on fantasy.
- AMD simply doesn't have the financial capacity to outrun Intel over the long haul.
- We don't think AMD will ever create a blockbuster need to permanently reverse fortunes.
Advanced Micro Devices (NASDAQ:AMD) is talked about positively in many circles, but we can't see it ever being able to leapfrog Intel (NASDAQ:INTC) to substantial "economic" profitability. Intel, in many cases, sets the standard that AMD has to follow. Let's still take a look at shares and run them through the Valuentum process.
For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Advanced Micro Devices posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. Though a 6 is not terrible, it is not a 9 or 10 either -- the latter two ratings equivalent to a "we'd consider buying" rating.
Advanced Micro Devices' Investment Considerations
- AMD earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 70.7% from 34.2% during the next two years.
- AMD is a global semiconductor company. The firm makes x86 microprocessors, as well as graphics, video, and multimedia products for desktop and mobile devices. Its solutions, for example, power the newest gaming and entertainment consoles from Microsoft (NASDAQ:MSFT) and Sony (NYSE:SNE).
- Intel has dominated the microprocessor market for years, and we don't think that will change. Intel's market share, margins, and significant financial resources will continue to pressure pricing and profits at AMD. AMD must innovate to survive, and we think it needs to accelerate its transition to growth markets: semi-custom solutions, ultra-low power client PC, embedded, dense server, and professional graphics.
- AMD's strategy is somewhat conservative. The firm is focused on managing its cash balance and securing revolver availability, and it has cut operating expenses materially to stem income declines. We're not confident AMD will right the ship.
- We simply do not think AMD has the R&D capacity to keep up with Intel, which often dictates the type of products the market requires of AMD. We don't see AMD ever escaping this competitive disadvantage.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Advanced Micro Devices' 3-year historical return on invested capital (without goodwill) is 16.6%, which is above the estimate of its cost of capital of 10.5%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Advanced Micro Devices' free cash flow margin has averaged about -1.2% (negative) during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Advanced Micro Devices, cash flow from operations dropped into negative territory from levels two years ago, while capital expenditures fell about 66% during this time period.
Our discounted cash flow model indicates that Advanced Micro Devices shares are worth between $3-$7 each. Shares are trading just shy of $4 at present. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $5 per share represents an implied EV/EBITDA multiple of about 14.7 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 3.9% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate. Our model reflects a 5-year projected average operating margin of 6%, which is above Advanced Micro Devices' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.6% for the next 15 years, and 3% in perpetuity. For Advanced Micro Devices, we use a 10.5% weighted average cost of capital to discount future free cash flows.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Advanced Micro Devices to peers Intel and Texas Instruments (NASDAQ:TXN).
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $5 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Advanced Micro Devices. We think the firm is attractive below $3 per share (the green line), but quite expensive above $7 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Advanced Micro Devices' fair value at this point in time to be about $5 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Advanced Micro Devices' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $7 per share in Year 3 represents our existing fair value per share of $5 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
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In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Additional disclosure: INTC and MSFT are included in the newsletter portfolios.