AMD Stock: 4 Reasons For A Bull Thesis (NASDAQ: AMD)

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The investment thesis

This article analyzes Advanced Micro Devices (NASDAQ: AMD) from the perspective of its product portfolio and profitability and execution in recent quarters. The results show that AMD enjoys a strong product portfolio and the profit margins are rapidly expanding. Admittedly, there are still rooms for the margins to further improve. But whatever the business lags in profit margin, it more than makes it up in strong execution and product innovation.

Looking forward, we see the following catalysts to augment its profitability and support its stock price:

  • Its strong product portfolio will only get stronger. AMD currently features the best product portfolio arguably in the industry. And the portfolio is getting even stronger considering its Ryzen processors with 3D V Cache technology and differentiated solutions for heterogeneous compute enabled by the Xilinx acquisition. The latter will help AMD to tap into the growing computing demand across data centers, communications, and embedded markets.
  • Expanding margin. AMD has already been enjoying rapidly expanding margins in recent quarters and we see the expansion to continue or even accelerate with the Xilinx acquisition. The acquisition will add diversified revenue streams across multiple, high-margin businesses. It is expected to be accretive to non-GAAP margins, non-GAAP EPS, and free cash flow (“FCF”) in the first year.
  • In particular, we think the market underestimates the potential of its FCF margin. It earned a record FCF of $ 3.2 billion in 2021 on record revenue of $ 16.4 billion, resulting in an FCF margin of 19.5%. With the accreditation of Xilinx and higher-margin products, we are expecting at least 150 basis points FCF margin expansion in 2022, from 21% to 22%.
  • Lastly, valuation. Many potential investors are (or were) concerned about its high valuation. The recent correction has brought its valuation to about 28x FW PE, a very reasonable level when adjusted for its quality and growth.

Reason 1 – AMD’s strong product portfolio

AMD currently features the best product portfolio not only in its own history but also arguably in the industry. The product portfolio features a rich mix of products, ranging from high-end Ryzen ™, to Radeon., And to EPYC ™ processors. This strong product line addresses critical high-growth market sectors, including desktop and mobile computing, PC and gaming, GPU, data center, et al. Notably, thanks to its technological lead, many ADM chips are now achieving the best of both worlds in computing – leadership performance and lower power consumption (which leads to advanced battery life) at the same time.

Looking forward, we see the product mix to further strengthen. Its recently announced Ryzen processors with 3D V Cache technology is expected to power incredible gaming experiences, a high market. The Xilinx (XLNX) acquisition to further strengthens AMD’s strategic position. It substantially augmented its customization ability and is anticipated to be immediately accretive to the bottom line. The XLNX acquisition added the number-one provider of adaptive computing solutions to AMD’s business. This acquisition, coupled with organic growth, has management targeting annual revenues of about $ 21.5 billion this year, a more than 30% increase from the 2021 level.

AMD products

Source: AMD 2021 Q4 earnings release

Reason 2 – rapidly expanding margin

As can be seen from the next chart, the profit margin (I used operation cash flow margin here) has first stabilized for AMD since 2018 ~ 2019 and then really started to rapidly expand since Mar 2020. Since Mar 2020, it has improved from the negative to ~ 20% at the current level. Key drivers for such expanding margins are the higher Average Selling Prices (ASP). In particular, the client processor ASP saw strong growth driven by a richer mix of Ryzen desktop and notebook processor sales, and the GPU ASP, driven by high-end graphics products, including data center GPU sales.

Admittedly, there are still rooms for the margins to further improve. As shown in the figure below, the profit margin for Intel (INTC) is about 40% currently, exceeding that of AMD by a large gap. However, the 25% margin is nothing too shabby by itself. On average, the profit margin for the overall economy fluctuates around 8% and rarely goes above 10%. Of course, this is an average across all business sectors. Nonetheless, as a rule of thumb, 10% is a very healthy profit margin and 20% is a very high margin. So AMD’s current 25% is among the very high end compared to the overall economy.

Looking forward, we see the Xilinx acquisition to add diversified revenue streams across multiple segments. It enables differentiated solutions for heterogeneous computing to address a growing demand across data centers, communications, and embedded markets. We expect these opportunities to further expand margins across the board (ranging from non-GAAP margins, non-GAAP EPS, and FCF margins).

And furthermore, whatever AMD lags in profit margin, it more than makes it up by product innovation as mentioned above and also by strong execution, as discussed below.

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Source: author and Seeking Alpha data

Reason 3 – strong execution and strong growth

The next chart shows the asset turnover rate (“ATR”) for AMD in recent quarterly. The ATR measures how efficiently a company uses its assets to generate revenue. The higher the ATR, the better the company is performing, since higher ratios imply that the company is generating more revenue per dollar of assets. As seen, AMD’s ATR has been quite stable around an average of 0.35 on a quarterly basis, and hence about 1.4 when annualized. ATR is a knob that management can consistently tweak to suit its operations, and AMD has been turning this knob very effectively compared to tech companies. To put things into perspective, the ATR of Apple (AAPL) is currently at about 0.9 under Tim Cook’s leadership, a CEO known for his tremendous experiences and insights for streamlining operations. And the ATR for INTC is only about 0.7 in recent years.

In the end, the final profitability of business ultimately depends on profit margin and asset turnover rate, assuming similar leverages (which is a good assumption because large mature businesses such as AMD, INTC, and AAPL all have similar levels of leverage). So AMD’s current lag in profit margin (25% vs 40%) has been more than made up by its ATR.

And furthermore, AMD also has a strong growth on its side with its strong product line as mentioned. The revenue has almost doubled in the past year as seen. And management’s outlook for next year’s growth is ~ 30%.

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Source: author and Seeking Alpha data

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Source: AMD 2021 Q4 earnings release

Reason 4 – very reasonable valuation after recent correction

Many potential investors are (or were) concerned about AMD’s high valuation. Indeed, even a few months ago, back in Nov ~ Dec 2021, AMD was trading at about 42x PE. However, AMD’s current valuation is actually quite reasonable after the large price correction YTD and also its Xilinx acquisition. The current FW PE is about 28x, a very reasonable level especially when you consider its quality and growth potential.

To evaluate the valuation risk, what I always like to do is a simple reality check as shown in the chart below. It is essentially a back of envelope calculation to estimate what is the growth rate and valuation required to deliver a target ROI in the next few years, say 5 years. And see if such growth rate and valuation can pass a common-sense test.

As an example to provide a tutorial to read this chart, if we require a 10% annual ROI, represented by the red line (10% annual return translates to 60% total return in 5 years because 1.1 ^ 5 = 160%), the growth rate will have to be about exactly 10% if the PE ratio does not change from its current level – something we all know already. And if the PE contracts to 25x (essentially the average market valuation) as shown by the green line, the growth rate would have to be about 16% to deliver the required 10% ROI.

With the above background, we can see that the current valuation easily passes the reality check. To put things into perspective, AMD almost doubled its revenues from 2020 to 2021 (from $ 9.7B to about $ 16.4B). And management’s outlook for next year’s revenue is $ 21.5B, reflecting a growth rate of more than 30%. It is likely that management is being conservative with this outlook. It helps them when they set a conservative target, and then report actual numbers that exceed the target – like what has happened in the past quarter. But even the growth actually turns to be what the current outlook is, it already far exceeds what is needed to justify the current valuation as seen – even if the valuation compresses substantially – and still deliver a healthy return. Actually, even if growth slows to about 12.5% ​​AND valuation contracts to 25x PE (as shown by the lower bound of the yellow box), the investment would still not lose and make a decent profit.

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Source: author and Seeking Alpha data

Conclusion and Risks

This article analyzes AMD both as a business and an investment. As a business, AMD enjoys a strong product portfolio, rapidly expanding margins, strong execution – all leading to strong growth. And as an investment, it features a very reasonable valuation when adjusted for its quality and growth. More specifically,

  • AMD currently features the best product portfolio not only in its own history but also arguably in the industry. And the portfolio is getting even stronger with its product lineups and the Xilinx acquisition.
  • The profit margin has turned a corner in Mar 2020 and has expanded rapidly to the current level of ~ 20%. Admittedly, 25% is still behind other mature businesses such as INTC, whose profit margins are around the 40% level. However, we see plenty of room and catalysts for its margins to further expand. And whatever the business lags in profit margin, it more than makes it up in strong execution and product innovation.
  • AMD’s execution efficiency, as measured by the asset turnover rate, is about 1.4 on an annual basis. It is higher than AAPL by about 55% (and remember AAPL is headed by a CEO known for his tremendous experiences for streamlining operations), and about 2x of that of INTC.
  • Lastly, the current valuation easily passes the reality check. The current growth outlook far exceeds what is needed to justify the current valuation – even if the valuation compresses substantially – and still deliver a healthy return.

The risks include:

  • Macroeconomic risks. The ongoing interruptions of the global supply chain create a major macroeconomic risk. The supply chain shock is still unfolding and could develop in many possible directions, especially with the new COVID variant appearing, China restarting lockdown mode in key cities, and the Ukraine / Russian situation still ongoing.
  • Valuation. Even after the recent correction, AMD is still trading at a significant premium against its peers. For example, both INTC and QCOM are traded at about 13 ~ 14x FW PE. Such a valuation premium, combined with the macroeconomic risks, could lead to short-term large price volatility risks.
  • Competition. Companies in the semiconductor industry are in a constant race to build smaller, faster, and cheaper chips. AMD competes directly with Intel, NVIDIA (NVDA), QUALCOMM, et al. The competition is not only limited to chip design but also extends to other areas such as manufacturing. AMD, for example, has a risk of losing its console business if Intel’s Foundry Services becomes online and successful because cost is a critical factor in the consoles business.



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