The Market Keeps Ignoring How Bad AMD Really Is

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About: Advanced Micro Devices, Inc. (AMD), Includes: INTC, NVDA
by: Aleksandar Vichev
Summary

AMD's financial results have been terrible for many years.

Investors still believe that "this time it's different" due to late-cycle optimism.

AMD stock can still climb higher, but it remains a gamble and not an investment.

Introduction

AMD competes in an industry broadly known as semiconductors, which is known to be extremely cyclical. This very cyclicality makes AMD incompatible with any sustainable long-term investment returns, not to mention the company's weak financials throughout many cycles. Despite its high-flying stock and promising new products, I don't believe that "this time it's different." Even if it is, the company's rich valuation is another concern by itself.

Thesis

In "The Five Rules for Successful Stock Investing," Pat Dorsey gives AMD (AMD) as an example of a company you wouldn't want to be invested in. His logic was very simple: rare annual profits outnumbered by many years of large losses, high capital expenditures leading to negative free cash flows and last, but not least - an extremely cyclical business. The book was published in 2004.

In 2019, a quick glimpse at AMD's financial statements shows that not much has changed in the past 15 years. The company still cannot be relied on to produce consistent results. 2018 was AMD's first year with positive net income since 2011. This, however, was just an accounting profit as the company's free cash flow was a negative $129 million. Of the past seven full years, AMD managed to show positive free cash flow only in 2016 - $13 million. The company, meanwhile, is valued at over $34 billion. Mr. Market must be out of his mind.

AMD Earnings and Revenue Record 2005-2018 Source: AMD SEC Filings

The chart above reveals AMD's performance since 2005 to illustrate what happens to the company's bottom line when the economy contracts. It lost north of $3 billion in both 2007 and 2008. Despite "earning" $471 million in 2010, free cash flow was once again negative.

A cyclical business, but a steady diluter

Since the company keeps losing money but also aims to reduce its debt load, what does it do? It issues new shares every year, diluting existing shareholders' investment. In 2014, the average number of diluted shares outstanding was 768 million. In 2018, it was 1.06 billion. That is a 38% increase in just five years.

In my opinion, raising equity capital to fuel growth would make sense if AMD was profitable or at least fast-growing. But AMD is no Facebook (FB) or Amazon (AMZN). In fact, despite the strong revenue growth since 2015, AMD's sales in 2018 were still lower than in 2011. That is because if you check the word "cyclical" in the dictionary you might just find a picture of AMD's logo.

AMD cyclicality illustrated Chart by TradingView

And the fact that AMD kept losing money while Intel (INTC) and NVIDIA (NVDA) were posting record profits shows one more time what a bad company AMD really is. If a cyclical company can't make a buck during the upturn, imagine what will happen when the next downturn arrives and revenues start falling again. I think something similar to 2007-2008.

There is no smoke coming out of AMD's smokestacks

The legend goes that during the Depression in the early 1930s, Bernard E. Smith, also known as "Sell 'Em Ben," was looking for stocks of companies that were seemingly defying gravity and holding up. Being a perma bear, he thought no company was worth anything, so he was looking for stocks that haven't crashed yet.

A medium-sized industrial company caught his eye, so he went to the factory to see how things were going. Well, management was not very happy to see him and turned him at the door. With no other choice, Sell 'Em Ben started walking around the factory. Soon enough he noticed that of the five smokestacks of the factory, only one was belching forth smoke. In Bernard Smith's mind this meant one thing - the other four were not working, so business was bad. He rushed to the telephone and immediately shorted the company's stock. Several weeks later, the stock crashed following a poor earnings report.

In the 21st century, there is an equivalent to Bernard E. Smith's smokeless smokestacks. The two red flags investors cannot afford to ignore, especially when dealing with a cyclical company, are inventories and accounts receivable. If inventories are rising much faster than sales, it means demand for the company's products is falling. A huge surge in accounts receivable means the company is forcing sales by not collecting the money. The table below compares AMD's sales to its inventory and receivables levels.

AMD Source: AMD Financial Statements

As visible, sales have been rising at a good clip and inventories were not piling up. What bothers me is the huge surge in receivables. While sales climbed 23% in 2017, receivables rose twice faster. In 2018, sales climbed 23.4%, but receivables nearly tripled.

To make matters worse, revenues in H1 2019 were lower than in H1 2018, while receivables are still on the rise and inventories are starting to pile up as well. The next downturn hasn't even arrived yet, but AMD's business is already deteriorating.

What if it really is "different this time?"

I've read numerous articles about AMD's promising new products and how it can finally be ready to take on Intel. And indeed, Intel has somewhat been resting on its laurels, while AMD came up with the Ryzen Gen 3, which is not only cheaper, but also thought to be better than the competition.

I admit I am not a tech expert of any kind, but this guy is and he thinks there is a paradigm shift in the computer industry right now. Apparently, AMD is attacking Intel in every single segment, including datacenter, gaming and PCs. Offering better but cheaper products is a double-edged sword, but it looks like this is the tactic management has chosen to try and steal market share from competitors. For now, it seems to be working and if they manage to keep it going for a few more years, who knows, Intel might have to run for its money.

The first problem is that in the tech business a few more years equals eternity and time is not on AMD's side. Intel was resting on its laurels, because until recently, the company didn't really have any real competition. Now it does, but being the bigger and more profitable company, they have the resources to respond, too. AMD, on the other hand, keeps burning cash and will have to keep coming up with newer and better products in order to defend its fragile lead.

The second problem is that even if all the hype turns out to be true, AMD will have to make miracles to justify its valuation. Intel is trading at a forward P/E of 11.5. In order to justify its market value of $34 billion with the same P/E ratio, AMD will have to come up with an annual profit of $2.95 billion. That is a very ambitious task given its poor earnings tradition.

Conclusion

AMD is and always has been a bad company. None of the previous CEOs managed to change that fact and I doubt Lisa Su can either, despite all her good intentions and abilities. As Warren Buffett once wrote, "a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row." Not only is AMD a leaking boat, but it is also an obscenely overvalued leaking boat.

This is not a short recommendation though. If the stock went this high it can always go even higher. My point is that people willing to bet some money on AMD should not be calling it an investment. It is just a gamble and the long-term odds are not in your favor.

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.