AMD: Overvalued And Caught In The Storm

Summary

• The company is currently overvalued based on its revenues, in our view.
• Supply storm will evolve from blessing to curse for semiconductor manufacturers.
• General economic climate sets the stage for some brutal price corrections.
• We believe the company should be valued at $69.79 per share, although increased market exaggeration may push price lower.

There are two reasons why I generally like Advanced Micro Devices, Inc. (NASDAQ:AMD). The first one has to do with, when back in the day when I was a student, I managed to buy a brand new $250 graphics card with money earned from working as a waiter. If I recall well, it was an AMD Radeon HD7700 and introduced me in the fantastic world of Bethesda's Oblivion (gamers should know).

The second reason is because in general it is a fantastic company. It has staged an amazing turnaround over the past five years, more than doubling its revenues. The company has transcended from reporting losses in 2016 and 2017 to reporting EPS of 2.10, almost 6 times higher than that reported in 2019. The company has shown phenomenal growth in the worst of times.

The efforts of the company have not gone unnoticed and the stock price is a reflection of this fast-growing tech innovator. However, a more important question is if the stock price is too generous a reflection of the value of the firm. Currently, the stock is trading for roughly 10 times its annual revenue of 2020. Its market cap is $102 billion with 2020 sales of $9.7 billion. According to the annual accounts of the company it does not seek to pay any dividends in the near future. While the main reason to own AMD is momentum, this momentum seems to be running out.

The semiconductor industry has witnessed a surge in demand due to the COVID-19 induced lifestyle. With the effects now mostly under control, the work from home demand has started to fade. With auto demand rebounding in 2H 2020 and stockpiling by companies, the supply shortage is only worsening. The chip shortage that served to be favorable until Q4 2020 in face of growing profits due to higher prices, is expected to create real damage when it will act like a constraint to product manufacturing. In Q4 2020, AMD lost its PC market share citing "supply constraints" as the reason, warning that this will continue till 1H 2021. The company also mentioned 'tightness' of supply in the period with models of Ryzen 5000 CPUs and Big Navi graphics cards. AMD outsources its chip manufacturing, exposing it to an estimated >20% chip cost exposure. Keeping all this in mind unlike 2020, simply raising prices cannot make up the loss in revenue in 2021.

AMD is competing in graphic processors with Nvidia (NVDA) and has managed to make smaller and faster microprocessors than Intel (INTC). Some of the excitement over AMD represents the products differences as compared to those of Intel. While Intel struggles to make 10nm processors, AMD is making processors in 7nm. The main difference here is that CPU’s that are smaller in size can fit more microchips in less area while consuming much less energy. This has become more important in the last few years. Moreover, AMD has patented X64 extension, so now Intel buys it from AMD, leading to some applications working better on AMD, then on Intel.

If past experiences are any indicator, although AMD has overcome Intel in terms of performance before, those previous wins against the tech giant have been rare over the years. Every time Intel has been pushed to the fence, it has managed to respond swiftly and effectively. For example, in 2005 when the AMD Athlon 64 X2 dominated the 64-bit world, Intel introduced its Core architecture in mid-2006, solidifying Intel's dominance over AMD. This was followed up by quad-core offerings by Intel in the next year which were clearly faster, more efficient and better priced than what AMD was able to offer.

With bond-yields increasing, the US-economy is expected to increase interest rates earlier than expected. As recent evidence suggests, the capital markets might be staged for a setback. One of the biggest blows might be delivered to the tech companies due to perceived overbuying in the sector. On Thursday, Federal Reserve Chairman Jerome Powell commented that the central bank’s current policy stance is appropriate and suggested that moves in inflation are transitory. The statement led the main stock indices to consecutive red days, while on Friday, averages ended up on the green. However, we believe that volatility will continue to be the main character in the following days play, which, in combination with the bubble rhetorics that have started to gain traction, could create a situation that will be not so pleasant to the average investor.

The Numbers

Let’s now have a look at the fundamentals of the business. According to the company's 2020 annual report, AMD’s return on assets of 27.78% and return of equity of 42.62% outperforms the industry average of 3.36% and 10.80% respectively. Moreover, AMD reported a profit margin of 25.5% this year whereas the industry average was 3.64%. Although, the profitability ratios of the company far outperform the industry average it still does not justify its current market price. The company is trading at 16.4 times its current book value compared to an industry average of 3.73. In addition, the company currently has a P/E ratio of 40.76x as opposed to the P/E ratio of one of its biggest competitors Intel which is trading at a P/E ratio of 12.4x. Even at the EV/EBITDA front, AMD seems to be overvalued as the industry averages 16.82x vs AMD’s EV/EBITDA ratio of 55.26x.

Source: Self conducted valuation

Within the context of this article, we conducted a 5 year DCF analysis of the company. As inputs, we used the 5Y revenue forecast CAGR of 15%, an average EBITDA margin forecast of 25%, a discount rate of 9.5%, and a terminal EBITDA multiple of 20x. According to our valuation, AMD's fair price is $69.79 per share.

Technicals

On the technical front, the stock is trading both below its 50-day moving average, forming lower lows on the daily RSI. All of the above combine to create a not so favorable investment case. Yesterday, the $74 support was confirmed but we believe next week the price will head south of that level. In the near future we expect to see a pull back in the $70-$74 zone and we anticipate that the price will likely remain in that area for some time. If things get more spiced up with external negative factors, the share price will get hit harder and possibly move below our derived fair value, at least for a relatively short period of time.

Conclusions

In conclusion, the reason for the overly optimistic price of the stock is due to a boost in sales which can be attributed to COVID-19 and the company's current edge over Intel. The negative sentiment surrounding capital markets due to the expected increase in interest rates and supply shortages of semi-conductor chips are set to adversely affect AMD. This fact, coupled with both fundamental and technical analysis, have led us to believe that the stock is currently overvalued. The current economic climate may amplify this situation, resulting in significant price reduction in the near term.

Analyst’s 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.

This article was written for information purposes only. The contents of this article should not, in any case, be considered as an urge to buy, hold or sell securities. Always perform your own research before investing in the stock market.