AMD Stock: Improving Narrative, But Warrants Caution

There's too much optimism around Advanced Micro Devices Inc (AMD) stock now warranting cautious investment approach.

Shares of Dr. Lisa Su led AMD (NASDAQ:AMD) had an amazing run in 2016 delivering almost 3x returns but failed to live up to the expectations in 2017 ending with negative returns. However, AMD stock has got a major boost after the 2018 first-quarter earnings. The bullish narrative around the chipmaker had just recently sent the stock price to an 11 year high. A series of analyst upgrades have also helped the stock's cause. AMD stock had shot up more than 70% since its first-quarter earnings and is still up more than 50% in the year to date period. With such rapid gains, there are always concerns about company's valuation. In this post, we shall have a look at what's working for AMD and what are the bets which need to come through for AMD to sustain the high valuation.
AMD stock chart

Source:AMD stock price chart by amigobulls.com

Server market: The key to AMD's future growth.

In the last earnings call, both CEO Dr. Lisa Su and CFO Devender Kumar highlighted that EPYC server processors ramping contributed significantly to the company's impressive revenue growth. EPYC server chips have recently completed one year since their launch and a lot has changed in the server landscape. AMD has had several big wins in the server market with Cisco (NASDAQ:CSCO) becoming the latest player to adopt EPYC processors. Research agencies Gartner and IDC in their reports stated that global server market posted record revenues in Q1 2018 and suggested that hyperscale cloud providers are ramping up with enterprises upgrading their infrastructure. According to Gartner, "the server market is being driven by renewed interest in the hyperscale, data centers, and investment by everyone from enterprise players to SMBs seeking to update their infrastructure, abandon legacy systems and sign up to new technological solutions."

The last few lines sound very good for the Sunnyvale, California based semiconductor company as its arch-rival Intel (NASDAQ:INTC) has almost 99% market share in the server market. With enterprises open to new solutions, we can expect many more new wins for AMD in the near future in the data center segment. Further, the customers in the server market are very conservative and demanding, they don't adopt anything new because some new product is available. Gartner's comments and the traction which the EPYC chips have witnessed since its launch clearly suggests there is increasing demand for change in this space and EPYC could give Chipzilla a run for its money. This is not new news. Recently Nomura Instinet analysts strongly stated that AMD may take significant server share from Intel in the second half of the year based on their interaction with Intel's recently departed CEO Brian Krzanich. To quote from the report, "Mr. Krzanich did not draw a firm line in the sand as it relates to AMD’s potential gains in servers; he only indicated that it was Intel’s job to not let AMD capture 15-20% market share."

AMD presently has about only ~1% market share in the server market. To put things into perspective, Intel's Data Center Group (DCG) had a revenue of $5.2 billion in Q1-2018 while AMD's entire enterprise, embedded, and semi-custom (EESC) segment in Q1 2018 made just $532 million, nearly one 10th of the latter. If AMD manages to achieve its target of the high single-digit market share by the end of 2018, that would significantly boost the company's revenues. With the company launching next-gen EPYC chips in early 2019, things could get really interesting. The latest reports from wccftech suggest that AMD Zen 2 based 7nm Rome server processors have been designed to compete favorably even with Intel's upcoming Ice Lake-SP Xeon CPUs. It appears that AMD is set to mount a strong challenge in the server market and reportedly Intel could lose $4 billion in server revenues to Intel.

A lot is riding for AMD on its shift to 7nm.

AMD's shift to 7nm couldn't have come at a better time. Intel is still struggling to ramp up its 10nm manufacturing processes. It could be very difficult for AMD to capture the kind of client and server market share which it intends to just having performance and price/performance advantage at 14 nm. Similarly, the Sunnyvale based semiconductor company cannot pose a great challenge to NVIDIA (NASDAQ:NVDA) as well when it comes to GPU compute with the 14nm chips. Hence, AMD has put its bet on its 7nm chips. For example, a Next Platform author, in his post highlights a key point: as per the roadmap shared last June, the company was planning to release a refined 14+ nm kicker to Vega and then subsequently shift to Navi at some point about halfway between 2017 and 2020. However, the Vega's successor is coming in with 7 nm this year, followed by Navi at 7nm and a next-gen unnamed GPU to follow in 2020. All these suggest that AMD is very confident of its 7nm manufacturing and things are turning out better than expected. One could expect more performance and better power efficiency with the 7 nm processes, and if these products turn out to be competitive to Intel and NVIDIA's upcoming launches, then AMD has a good chance to improve on its market share. Having said all these, Intel and NVIDIA will come out hard as well.

Improving numbers but still, concerns remain

AMD stock took off on strong earnings numbers with revenue jumping 40% YoY to $1.65 billion and also providing a strong outlook for Q2 at $1.725 billion, plus or minus $50 million, a 50% YoY increase. The Net Income also remained positive at $81 million. However, the company has failed to move the needle when it comes to free cash flow. In Q1 2018, the free cash flow came in at negative $132 million. One can understand that a company investing a lot in growth to have negative free cash flows but AMD has to generate tremendous cash flows in the coming quarters to compensate for the recent cash burn. The negative cash flows may hurt AMD hard and leave it in a precarious situation as it has an obligation to repay $156 million of its debt in FY 2018. Further, the company has some senior notes due in 2019. If the free cash flow situation doesn't improve much in the coming days then it can take a toll on the company's cash position. From the past statements of AMD, $600 million is supposed to be AMD's bottom threshold of minimal cash. If the cash comes closer to this mark then, it could hurt the company's operations.

AMD revenue chart

Source: AMD Revenue Chart by amigobulls.com

Summary.

In addition to the balance sheet risk, Investors must also be cautious about the company's valuation. AMD stock is trading at very high multiples. AMD's trailing twelve months PE is around 83x.  AMD's earnings need to grow rapidly and a lot of this is riding on the gains in the server markets and the 7nm products. This growth will be driven by revenue but also needs to be backed up by improvement in margins. In Q1 2018, the operating margin reached 7.29%, near the highest levels in last 5 years.

With AMD stock already up more than 60% since last earnings, the upside could be limited from here. To sustain the high valuation the company's latest bet's should come true. The sentiment around AMD stock also has changed recently with a number of analyst upgrades. The latest short interest to be released this week will give us a better idea of the sentiment around AMD. Having said that, despite the strong operational and financial outlook, investors must be cautious while investing in AMD stock. Most of the good news is already baked into the stock price. The launch of new products only could be the next big catalyst for AMD stock.


Sreekanth Anasa Sreekanth Anasa   on Amigobulls :

Neither Amigobulls, nor any members of its staff hold positions in any of the stocks discussed in this post. The author may not be a certified/registered investment advisor, and the opinions expressed should not be treated as investment advice.

Buying and selling of securities carries the risk of monetary losses.Readers/Viewers are advised to carry out their own due diligence and consult their investment advisors before making any investment decisions.

Neither Amigobulls, nor the author have any business relationship with any of the companies covered in this post.

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