Advanced Micro Devices: The Better Data Center Play

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About: Advanced Micro Devices, Inc. (AMD), Includes: INTC, MLNX, NVDA
by: Stone Fox Capital
Summary

Nvidia bought Mellanox for premium to advanced high-performance computing in data centers.

AMD trades very favorably compared to Mellanox at the buyout price of $125 per share.

The overlooked AMD story is vast gross margin improvements from sector low levels of 40% to industry norms above 60%.

Nvidia (NVDA) bought Mellanox Technologies (MLNX) in order to boost opportunities in the surging data center space. The valuation paid on growth projections for Mellanox places our investment thesis squarely back to bullish on Advanced Micro Devices (AMD).

AMD Epyc logo Image Source: AMD website

Big Premium

Nvidia agreed to pay $125 per share in cash to acquire Mellanox. The deal values the semiconductor at an enterprise value of $6.9 billion.

The deal is forecasted to be accretive to Nvidia on both an EPS and free cash flow basis, but the company pays nearly double the October lows of $65 to buy Mellanox. In addition, Mellanox is expected to drastically pull back on growth rates after reaching more than 33% in Q1 2018 with a forecast for only 10% revenue growth in 2020.

For this reason, AMD becomes a more interesting data center stock as the CPU chip company expects to ramp growth up to 20% next year. At this rate, AMD will have faster growth than Mellanox, though the stock trades at a lower P/S multiple. At a point last year, AMD traded at a premium forward P/S multiple and a similar level to Mellanox now at over 4.5x sales.

Chart Data by YCharts

As well, the deal valuation closes the P/E gap. With AMD on pace for EPS to surge to nearly $1 next year, the stock already is coming down to a more reasonable forward P/E of 24x. The number closes the gap with this value paid for Mellanox, further using more reasonable targets of $1.25 to $1.50 per share.

Note that Mellanox has gross margins of 69% and AMD is on the path to much higher margins after only recently topping 40%. The below chart highlights the vast difference in the GAAP gross margins for these stocks, including Intel (INTC). The non-GAAP gross margins for the group are much higher.

Chart Data by YCharts

AMD remains the only company that can't achieve margins of even 50%, much less more than 60% along with this group. The company has made significant progress in the last year, reaching 39% gross margins for the year, up from 34% last year. The last couple of quarters finally topped 40% and the expectation is for further gross margin gains in 2019 with a forecast to at least exceed 41% for the year.

Source: AMD Q4'18 presentation

Data Center Potential

Nvidia is buying Mellanox Tech to expand a current collaboration in building fast supercomputers. Per Nvidia CEO Jensen Huang:

The emergence of AI and data science, as well as billions of simultaneous computer users, is fueling skyrocketing demand on the world’s datacenters. Addressing this demand will require holistic architectures that connect vast numbers of fast computing nodes over intelligent networking fabrics to form a giant data center-scale compute engine.

Depending on whether using internal server market estimates from AMD or external from Mercury Research, AMD has either 3.2% or 5% of the server chip market share. The actual percentage just isn't really meaningful because investors already know the revenues and the growth rates with either estimate accounting for substantial market share gains.

According to Mercury Research, the company more than quadrupled their server market share in the last year from 0.8% to 3.2%. The plan with the 7nm Epyc 2 chip is for AMD to end the year closer to 10% market share and my projections are for the company to eventually capture 20% market share similar to the peak levels back in 2006. The Mercury Research numbers will be lower due to using a different calculation for server unit estimates.

Source: Mercury Research

Regardless, AMD is clearly positioned to grab more market share in the data center server space. According to research from Spiceworks, AMD is positioned to grab work with 8% of enterprises planning to start using their chips in the next two years. While this report doesn't address the market share with those enterprises, the company is forecast to shift from only 16% penetration to 24% or the equivalent of 50% growth in the amount of businesses that plan on using AMD for server processors.

Takeaway

The key investor takeaway is that AMD remains best positioned to grab market share in the data center space. Along with substantially higher gross margins of just around 46% and revenues of $10 billion, the company hits an EPS of $1.50 per share. Further upside exists on even higher gross margins, making AMD still a cheap way to play data center growth.

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.

Additional disclosure: Disclaimer: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.