Advanced Micro Devices (NASDAQ: AMD) has done extremely well over the past year. Its revenue growth has entered into the positive territory and its shares have risen by over 300% during the past 12 months alone. Yet, even after this remarkable recovery, we keep stumbling upon speculative discussions about how the company has a high probability of going bankrupt. In fact, it was only last month that fellow Seeking Alpha contributor, The Structure of Price, suggested that AMD is in distressed zone and should be shorted primarily because its Altman Z score is negative and lags that of Intel (NASDAQ:INTC) and Nvidia (NASDAQ:NVDA). But that's not necessarily the case here.
Understanding the Z Score
Before we begin the argument, let's first understand what the Altman Z Score is really about. The formula was developed in 1968 to predict the likelihood of corporate bankruptcies. We take past financials of the concerned company, calculate its business ratios, attach a prescribed weightage to these ratios and then arrive at the final figure which is known as the Altman Z Score. The formula goes as follows:
Z = 1.2*A + 1.4*B + 3.3*C + 0.6*D + 1.0*E
The variables mentioned above are simply business ratios and their coefficients are basically the weightages that we just discussed about. These business ratios are:
A = Working Capital / Total Assets
B = Retained Earnings / Total Sales
C = EBIT / Total Sales
D = Market Cap / Total Liabilities
E = Sales / Total Assets
The formula has a provision for three classifications only. They are:
If Z score > 2.99, the company is said to be in the "Safe" Zone
If 1.81 < Z Score < 2.99, the company is said to be in the "Gray" Zone
If Z Score < 1.81, the company is said to be in the "Distressed" Zone
Now let's get down to the nitty-gritty of it all. I went through the past financials of AMD, Intel and Nvidia and calculated their respective Z Scores. The results attached in the chart below reveals that AMD's score is the lowest amongst the three companies. And going by the classification provided above, AMD does fall into the distressed zone. But does that mean AMD should be shorted?
A common misconception is that companies that have a negative Altman Z Score, carry a high amount of risk and are headed for bankruptcy. Why? Because the formula said so? The thing is, you can use this predefined filter to spot financially stressed firms but can't really short companies based on this limited information.
A key factor to consider here is that the Z Score is a lagging indicator. This essentially means the indicator will start to show signs of change only after major financial shifts in concerned companies have already taken place.
A company (let's say AMD?) may be in the process of staging a turnaround of its lifetime, but the Altman Z Score would still call it distressed for the next several consecutive quarters because of its lagging nature. Now shorting such kind of a firm wouldn't be a good idea, would it?
The correct way to use the formula is,
- Screen distressed firms using the Z Score, then evaluate them with a forward-looking approach, or
- Evaluate how the Z score of a company is evolving over a period of time, to determine whether it's staging a turnaround or deteriorating even further.
Unfortunately, none of the two factors played any role in my fellow contributor's post. For starters, the chart attached below illustrates very clearly that AMD's Altman Z score has vastly improved over a period of just four quarters. I believe this is something that holds a lot of weightage. The company is showing clear signs of a financial turnaround, so naturally, shorting it would be like trying to catch falling knives.
Also, AMD will be releasing its Vega GPUs and Zen CPUs during the first half of 2017. Whether these releases would turn out to be raging successes or not, is a topic for another discussion. But we have to acknowledge the fact these releases would rake in at least some kind of additional revenues and profits for the chipmaker.
A consensus of 26 analysts covering the company suggests that AMD's EBITDA is projected to grow almost 6 times between 2016 and 2018. So, I fail to see how AMD will remain a "distressed firm" going forward.
Once we factor in these projected increments in AMD's financials, the chipmaker's Altman Z Score would obviously improve even further. I did some rough calculations based on these revenue and EBIT estimates and found out that its Z score would equate to somewhere 0.45 if all other metrics remained constant. If we also factor in a reasonable 30% increase in the chipmaker's market cap over the next 2 years, then its Z score further increases to 0.95. That's a sharp increase from the current -0.53, but that's not the end of it.
There have been recent reports suggesting that Intel could ditch Nvidia, and pick AMD from 2017 onwards, to power up its integrated graphics from thereon. If the $200 million-a-year worth of business actually comes to AMD next year, and we factor that in our forecasts, then AMD's Z score could further improve to 1.17.
The point that I'm trying to make here is that if you're basing an investment decision based on AMD's Altman Z Score, then you should be buying AMD, not shorting it.
We have to remember the fact that the Altman Z Score is a lagging indicator. This basically means that we have to use a forward-looking approach to derive any meaningful conclusions out of it.
As far as AMD is concerned, there are several positives lined-up ahead for the chipmaker (Zen, Vega, Navi to name a few) that stand to boost its financials, and its Altman Z score, in turn. Also, with the projected improvements in the chipmaker's Z Score, a few credit rating agencies might as well upgrade the chipmaker over the next two or three quarters.
So I don't think AMD should be shorted just because its Z score is negative.
Disclosure: I/we 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.