In this final part 3, I focus on debt analysis and I forecast the income statement for Q3 2016 and Q4 2016 to demonstrate that the company will not make money and turnaround its ailing business in the near future. Part 1 is about the business and margins, and part 2 analyzes the cash position and liquidity of the company.
Balance Sheet & Debt
Debt analysis points out more bad news for AMD's (NASDAQ:AMD) future. The company has a long term debt load of $2.148 billion with maturities starting 2019. They need to repay $600 million in 2019 and $450 million in 2020. With a current total cash of $957 million, the company has roughly 3 years to generate around $1 billion in cash to repay its first part of long term debt, if it wants to stay in the "optimal target" (i.e. between $600 million and $1 billion) . On top of that, AMD has to develop new chips in a highly competitive market and faces competitors with deep pockets of cash (i.e. Intel (NASDAQ:INTC) and Nvidia (NASDAQ:NVDA)). AMD could not generate any free cash flow for 4 years and now it must become cash flow positive in 2017 to ensure its future. How will AMD do that?
On the balance sheet side, AMD also has current liabilities of $1.581 billion and a stunning negative equity of $413 million. In the below graphic, you can see that AMD situation is deteriorating to the point of no return. As equity became negative quarter over quarter, Debt to Assets ratio escalates dramatically to 1.12 in the last quarter. "D/A" ratio represents the financial leverage of a company and shows the proportion of a company's assets financed with debt. From Q1 2013 to Q3 2014, "D/A" was already high at 0.9, representing assets financed by 90% of debt. Now, the company is fully financed by debt ("D/A" > 1). With negative equity, shareholder's value is 0, plain and simple. This is another major red flag.
On top of reimbursing its huge debt, AMD has to pay interests. And these are a major drag to become profitable. In fact, the company has $41 million to pay each quarter ($164 million annually). With a negative operating income quarter over quarter, this is quite difficult to achieve. AMD has to spend some of its cash reserve. In the below graphic, you can see AMD's interest coverage ratio quarter over quarter. Generally speaking, a ratio of 1.5 or higher would be considered acceptable to meet interest expenses without troubles. When you report a negative interest coverage ratio for 7 quarters in a row, you are in deep trouble. This is another major red flag.
How can AMD deal with that?
They need to generate a ton of cash. However, they cannot generate any from the business. In fact, free cash flow was negative by $232 million, $193 million and $322 million for FY 2013, 2014 and 2015, respectively. Furthermore, the company has already reported negative FCF of $174 million for the first 6 months of 2016. There is no improvement and I expect AMD to generate negative FCF of $350 million for FY 2016.
Please explain me how AMD could generate substantial positive FCF to pay $164 million of interest annually, repay its debt and invest in R&D to stay competitive in the GPU/CPU side when it burned roughly $1 billion in 4 years.
Forecasting of income statement for Q3 and Q4 2016
Given the guidance provided, I compute 3 cases (Bear, Base and Bull) which have different assumptions as shown in the below table. To arrive at the final result, I start with the total sales and gross margin, and then move on with sales per segment. Q4 should represent the peak for Semi Customs deals. As a result, I forecast a growth of 20% for the Enterprise, Embedded and Semi Custom segment with an operating margin of 10.94% (same as in Q2 2016) as base case. Regarding Computing and Graphics segment, I take the same operating margin as last quarter (i.e. -18.62%) as base case.
In the below table, I compute the sales per segment as well as operating income/loss per segment to show which parts are moving the business in the right (wrong) direction and where the company should focus to return to operating profitability.
Let's start with the good. EE&SC represents the bright spot and allows the company to mitigate its operating losses. I expect EE&SC sales to increase 20% for Q3 2016 and then decrease -15% for Q4 2016. As stated by Lisa Su, Q3 will represent the peak quarter in terms of semi customs deals, which is why I expect Q4 to be down materially. The -15% is critical to arrive to the annual guidance for 2016 ("low single digit revenue growth year-over-year"). Furthermore, C&G sales should also improve materially thanks to RX 480 and the soon to be released RX 460 & 470 based on the Polaris architecture, which is well received and experiences strong demand according to Conference Call and AMD CEO.
On an operating basis, I expect the company to report an operating profit for EE&SC segment of $77.72 million for Q3 2016 and $66.07 million for Q4 2016. On the contrary, C&G segment will continue to be unprofitable.
As shown in the below table, I expect a total operating loss of $25.65 million, having increased by $17.65 million from Q2 2016 and, a total operating loss of $39.09 million for Q4 2016. I don't see AMD to become profitable with C&G business anytime soon. While AMD's new products (Polaris based) and the much anticipated Zen are well received, I don't expect it to meaningfully change the negative margin coming in with. In fact, AMD's products are well received because on one hand, they are performing well but on the other hand, they are attractively priced to gain market share from Intel and Nvidia. If Apple (NASDAQ:AAPL) is using AMD chips, there is a good reason (good product, attractively priced).
Finally, I expect a net loss of $66.7 million for Q3 2016 and $80.1 million for Q4 2016. Even if the bull case shows an operating profit of $5.89 million, interest expense will make net profit negative. These numbers don't bode well for the future, as AMD will be unable to generate a profit for FY 2016. Unfortunately, the company has to pay interest each quarter and will have to find $1 billion in the next 3 years to pay back its debt maturing in 2019 and 2020. A potential solution would be to do a capital increase as the share price is currently high. This solution was discussed in part 2.
From a business point of view, the last hope of a successful turnaround comes with Zen, which will make or break AMD in 2017. Don't get me wrong, Zen must not be a success for AMD to comeback on the path to profitability and pay back its debt, but a really HUGE one. It has to gain significant market shares and come with high margins, which is unlikely in my opinion. I'm not the only one scared by AMD solvency situation, Fitch has downgraded AMD to CCC and withdrawn rating.
If you are buying shares in the $5-7 range, you have highly aggressive assumptions regarding future profitability, which looks like unachievable for two more quarters. Furthermore, don't forget the massive debt of $2 billion and, interest expense coming in each quarter to drag down net profit. Before betting the farm on a stock like AMD, I hope you bulls, carefully did you own due diligence.
Because remember that AMD is cooked.
Disclosure: I am/we are short AMD.
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.
Additional disclosure: I'm short AMD via Oct 2016 and Jan 2017 puts