Everyone likes an underdog story, but sometimes the underdog is in that position for a reason. For years Intel (NASDAQ:INTC) and Advanced Micro Devices (NYSE:AMD) battled it out for desktop and laptop processor supremacy. Unfortunately, AMD seemed to get the short end of the stick. The bad news for AMD investors is that they can expect more of the same in the future. In fact, there are at least three reasons to avoid trying to catch this "falling knife."
You either spend on this or you disappear into obsolescence.
If there is one thing that's certain in the technology industry it is that companies must spend heavily on research and development. There are countless examples of companies that didn't spend a significant portion of their revenue on R&D and were supplanted by others that spent more. Since a company can't spend what it doesn't have, it makes sense that a larger company can afford to spend more on R&D if the companies' margins are equal. With that in mind, consider the difference in R&D spending by three of the biggest players in the chip industry, and you'll see the problem right away for AMD.
R&D as a Percentage of Revenue Last Quarter
Arm Holdings (NASDAQ:ARMH)
Source: SEC filings.
At first glance, a few percentage points difference in R&D spending might not seem like that big of a deal. However, we are talking about difference in scale as well. Where ARM Holdings is concerned, the revenue comparison gets skewed because ARM primarily is a licensor of its technology and not a manufacturer.
However, the difference in sheer size of R&D spending between AMD and Intel is the first reason to avoid this falling knife. AMD spent about $1.2 billion on R&D last year, compared to over $10 billion at Intel. It's difficult to believe that AMD's R&D department can come up with groundbreaking technologies at just one-tenth the budget of Intel.
In addition, AMD's R&D spending seems to be declining as a percentage of revenue. For full-year 2013, AMD spent almost 23% of revenue on R&D. With the current quarter coming in at 19%, the company is going in the wrong direction.
Rarely do you thrive being the lowest margin player.
As a general rule, businesses that compete based on price are at a disadvantage. Sustainable competitive advantage comes from offering a better value to customers, a technological superiority, or some other factor. AMD has been competing on price with Intel in desktop and laptop processors for years, but margins on mobile chips are an even more daunting challenge.
If AMD hopes to make major progress, the company has to offer value to manufacturers instead of trying to offer the cheapest price. However, AMD's technology doesn't seem to warrant a premium price. If it did, the company's margins would almost certainly be higher.
AMD bulls would make the argument that the company's custom chips won over Sony (NYSE:SNE) and Microsoft (NASDAQ:MSFT) for their next-generation game consoles, and therefore custom solutions could be AMD's path to consistent profits. Some have even suggested that AMD receives as much as $100 per console sold, but there are problems with this theory. Game consoles are a highly specialized part of the industry and even robust sales pale in comparison to PC, server, or certainly mobile sales. Last year, the cumulative PS3 and XBox 360 sales reached more than 75 million. If the next-generation consoles surpass their predecessors, could sales of $100 million be achieved?
While this might seem like a huge opportunity for AMD, bear in mind the size of the PC and mobile marketplace. The estimated global installed PC base is well over 1 billion units, and even a year ago global smartphones exceeded 1 billion. The point is: AMD isn't going to win billions of dollars in contracts designing custom chips for PCs or mobile devices because both industries want standard designs at a reasonable price. Unfortunately for AMD, this means going with ARM for mobile and Intel for PCs at the present time. Looking at each company's gross margins bears this point out.
Since ARM Holdings focuses on licensing deals, the company's gross margin in the recent quarter was north of 95%. Intel, on the other hand, generated a gross margin of better than 64% compared to a margin at AMD of 35%. So, the second reason to avoid this falling knife is, quite bluntly, that the company's gross margin would have to nearly double to just catch Intel. To suggest that is possible is a tall order indeed.
The real bottom line.
Some analysts are hoping that AMD's revenue and net income improvement will be enough to increase the stock's value. However, this ignores the real bottom-line issue. The third reason to avoid AMD is the company's core operating cash flow (net income + depreciation) was significantly worse than last year. On a year-over-year basis, AMD's three-month core operating cash flow declined by 66%. Though ARM Holdings witnessed a decline of 40% by this same measure, Intel actually improved its operating cash flow by more than 25%.
The point is that AMD has a significantly lower gross margin than its peers. AMD also spends a lower percentage of revenue on R&D, and its operating cash flow has declined drastically. Trying to catch a falling knife like AMD could cause uninformed investors to see the value of their portfolio cut. This isn't an opportunity, but a trap.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.