AMD: Bright Future, Low Margin Of Safety

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About: Advanced Micro Devices, Inc. (AMD)
by: Roman Luzgin
Summary

AMD has successfully effected a turnaround over the recent years.

The company produces superior products, which leads to the rapid expansion of its market share. Several future events might still boost the earnings further.

The stock has tripled over the last year, which could potentially be a sign of overvaluation.

Therefore, the question arises: how much growth is currently priced in, and is there any margin of safety?

AMD stock has been a clear winner in recent years

Advanced Micro Devices (AMD) has gone a long way over the recent years. The company effected an impressive transformation from being an underdog and a loss-making corporation to becoming one of the leaders in the semiconductor industry. This resulted in the impressive growth in stock price that we have seen over the past three years.

Chart Data by YCharts

Several reasons could be called decisive in this journey, but it can all be summarized in one statement: AMD is developing and launching powerful CPU and GPU products that can compete with the products by the likes of Intel (INTC) and Nvidia (NVDA). This leads to increased market share and, as a result, the economy of scale, higher revenue, and better margins.

However, with the stock reaching its 13-year high, investors may start to pose a reasonable question: how much is priced in, and is there any room for further growth?

Certain future products and partnerships may boost the company's earnings even further

It is not a secret that the stock price is largely determined by the investors' expectations regarding the future of a company's business. When it comes to AMD, the semiconductor company has no shortage of valuable business catalysts, as it has a very strong product line-up for the next year.

For instance, during E3, AMD revealed its new 7nm Navi GPUs, Radeon RX5700 and RX5700XT. The graphics cards have all the latest technologies packed in one solution, including GDDR6 memory, 7nm process and a new architecture. Since AMD's process allows for a very small and efficient die size, the company can compete on price with similar products by Nvidia.

Moreover, a new 16-core gaming processor (Ryzen 9) was revealed. The chip also takes advantage of the efficiency brought by the 7nm process, which leads to great performance with lower power consumption compared to "the competition" (in this case, Intel's chips).

Additional catalysts include:

  • New consoles by Sony (SNE) and Microsoft (MSFT), which will use AMD's custom CPU and GPU and are set to launch next year.
  • Continuing success of EPYC server processors, with the 7nm Rome chip expected to launch in Q3.
  • Cloud gaming partnerships with Microsoft and Google.
  • Several collaborations with academia and the research sector.

So, AMD is well-positioned to increase its market share in several segments, which will ensure the company will continue to grow its revenues in the coming years. Now, let us determine how much of this growth is already priced in the stock.

How much is already factored in?

To analyze the current stock price, we will use a discounted cash flow (DCF) model with scenario modelling.

The model has certain static assumptions in order to have an initial framework for subsequent scenario modelling:

  1. The revenue will increase by around 10% in 2019, which is in line with the company's guidance given for the year.
  2. EBITDA margin will grow from the current 12.5% to 22% by 2021 and remain stable by the end of the horizon period.
  3. Balance sheet dynamics will remain similar to what has been observed over the last three years.

    AMD balance sheet modelling for DCF analysis
  4. The stock will trade at around 20-22 EV/EBITDA by the end of the horizon period (2023).

Having established the aforementioned assumptions, we can then model the estimated stock price relative to AMD's average revenue growth from 2020 to 2023. The graph below summarizes the findings in a concise way.

Scenario modelling shows AMD stock price relative to average 4-years growth

AMD stock price relative to a 4-year average revenue growth

It is clear from the analysis the market anticipates that AMD will grow its revenue by around 27-30%, on average, for 4 years starting 2020. It is worth noting that the current 3-year average (2016-2018) revenue growth amounts to 17.7%, with 10% growth forecasted for 2019 by the company's management.

Although the historical performance does not justify the optimistic assumptions driving the stock price at the moment, the business environment has never been more favorable for the corporation. Lisa Su, AMD CEO, explained this during the Q1 earnings call:

2019 is arguably the most important year in our history, as the $75 billion market for high-performance Computing and Graphics products has never been larger, and our product portfolio has never been stronger. We are right where we plan to be with our multiyear roadmap, including our upcoming 7-nanometer Ryzen, Radeon, and EPYC processors that can drive our next wave of revenue growth and share gains.

Moreover, AMD finds itself in a superior position relative to such competitors as Intel. The latter is currently struggling to launch a new family of products based on the 10nm process, which means AMD with its 7nm chips can provide better performance and efficiency, especially when it comes to the enterprise market.

There, AMD is expected to take a significant share of the market in the next 2-3 years (up to 10%, according to the source). With $21 billion in TAM for Datacenter, EPYC sales might generate more than $2.1 billion by 2020, compared to the corporation's $6.48 billion total revenue for 2018.

AMD estimates its TAM to amount to $75 billion

(Source: AMD earnings slides)

Final words

Overall, it is seen that the current price of AMD stock factors in a significant degree of expectations regarding revenue growth. Thus, according to the DCF model, the market prices a 4-year CAGR to be 30% starting 2020.

The corporation's product road map remains to be promising, primarily due to its superior 7nm process, which allows AMD to offer competitive GPUs and CPUs with lower costs and higher power efficiency. However, at $32-34, AMD stock does not provide a solid margin of safety for conservative investors, evident also by a 50 forward P/E ratio. This is why a pullback to $28-29 would be a more reasonable level to buy the stock for the long term.

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Disclosure: I am/we are long AMD, NVDA. 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.