Oct 19 2020 - AMD: A Gambler's Bet

Summary

Following an eternity of operational struggle, AMD finally turned the corner on the economic value creation front under its excellent leadership team.

Even as management successfully laid the foundation for future growth, investors must look elsewhere for capital distributions in the absence of buybacks and dividends.

Those who buy AMD today might wake up one day realizing the colossal disconnect between fundamentals and valuation in a painful way.

Written by the FALCON Team

Introduction

Just recently, we published our monthly “Tech Stocks On Sale” series, exclusive for Seeking Alpha readers, in pursuit of attractive technology companies our quantitative screening process might reveal. Following our deep-dive analysis on chip juggernaut Intel (INTC), we now move on with its archrival, Advanced Micro Devices (AMD), to examine whether today’s stark valuation contrast between the two can be justified by the latter’s superior business execution.

In light of Buffett’s teachings distilled from his 50+ years of shareholder letters, our analysis is based on the three dimensions that truly matter: operations, capital allocation, and valuation. Before we do that, however, let’s jump into what makes AMD an interesting candidate today.

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So what’s the story with AMD?

Advanced Micro Devices designs and markets an array of microprocessors for numerous computing applications, including CPUs (Central Processing Units) and GPUs (Graphics Processing Units) tailored to PCs, game consoles, and data center environments. The majority of the company’s sales stems from its Computing and Graphics segment (representing ~70% of AMD’s top-line), marked by its flagship Ryzen CPUs and Radeon GPUs. The segment’s dynamic, 45% YoY growth for Q2 2020 is underpinned by a massive expansion in unit shipments and a favorable pricing mix of AMD’s Ryzen processors. AMD’s growth trajectory was accelerated by a continuous market share gain over Intel, carving out a nearly 20% slice in both the PC and notebook processor fields as of Q2 2020.

The CPU market is relatively mature with limited opportunities for top-line expansion going forward. GPUs on the other hand could represent a source of dynamic growth, with the addressable market expected to almost double by 2025 (resting partially on cryptocurrency mining), driving the increasing demand for AMD’s Radeon processors, with a continued market share gain from the undisputed leader of the segment, Nvidia (NVDA).

On the contrary, AMD’s smaller Enterprise, Embedded, and Semi-Custom segment (representing only ~30% of the company’s top-line) has brought in a ~4% YoY decline, as sluggish demand for the company’s game console chips weighed on the segment’s performance. AMD’s EPYC server processors, on the other hand, are considered to be a true growth driver going forward (already achieving a 10% overall market share), although Intel still holds an almost exclusive position with its Xeon CPUs in the space.

As a conclusion, AMD is expected to achieve a strong, double-digit top-line growth through 2025, due to an expansion across each of its businesses, further enhanced by market share gains against Nvidia and Intel. The questionable side of the story is AMD’s intended acquisition of FPGA (field-programmable gate array) company Xilinx (XLNX) for a whopping billion. While the strategic rationale behind the deal seems sound, its sheer size contains severe integration risks that could jeopardize AMD’s overall bright outlook going forward. It is important to note as well, that while AMD's current momentum looks promising in both its CPU and GPU product lines, sustaining it might be difficult considering Intel’s and Nvidia’s significantly deeper pockets on the R&D front, coupled with their scale-driven cost advantage.

Operations

As a general rule of thumb, a company has authentic earnings power when it has both defensive and enterprising profits. Thus, when assessing a firm’s operations, we care about two fundamental aspects: it has to pass the cash flow-based stability test, and it must be a consistent shareholder value creator measured in the EVA framework.

Stability: Assessing Cash Flow Consistency

The most ruinous mistake you can make as a buyer of common stocks is to own a company that goes bankrupt. For this reason, the defensive investor judges the quality of a firm’s accrual profit based on its ability to self-fund. That is, whether it produces more cash from ongoing operations than it consumes, and not go deeper into debt or dilute current stockholders. When we look at the conventional financial statements, our primary concern, therefore, is the stability of the company’s cash generation.

48383446-16030234053274858.pngSource: Morningstar

In the case of AMD, the lack of consistency on the cash generation front leaves a lot to be desired, as the above table clearly reflects how the company has been burning through cash over the past decade. Or at least up until recently, as the turnaround efforts of AMD’s highly-appraised CEO, Lisa Su started to bear fruit, resting on a pronounced focus on high-performance computing. It is worth noting though, that the company failed to deliver a positive FCF balance over the past decade, due to the highly volatile and often negative OCF figures, caused by a weak product mix and a lack of sufficient scale up until now. Consequently, AMD fails our very first criteria regarding stability, warranting a massive red flag right from the start due to the company’s volatile operating performance. In the next step, we move on to the EVA (Economic Value Added) framework, examining if the company can consistently create shareholder value, as EVA cuts through accounting distortions and charges for the use of capital.

Value Creation: What type of moat rating is warranted?

We tend to prefer companies whose businesses are protected by large and enduring economic moats, as buying those companies at the right price generally leads to outperformance, as outlined in our research article. In the EVA framework, the EVA Margin (EVA/Sales) will be our ratio to define a company’s moat. A 5% EVA Margin can be used as an indicator for a “good” company, whereas persistence of a 5%+ EVA Margin for 10 years makes a company great and thus “moaty”.

Let's start by looking at the chart: AMD’s EVA Margin paints a rather negative overall picture, failing to enter into positive territory up until the beginning of 2020, as a result of the successful direction shift on the strategy front. Numerically, AMD’s EVA Margin has averaged -16.5% over the past decade, translating to a disastrous level of value destruction over the period.

As the main takeaway, despite AMD’s long-standing (and less capital intensive) fabless manufacturing setup, the firm is a prime example of why scale is extremely important in the semiconductor field since R&D costs weigh heavily on the sector’s margins, hence the stark contrast to Intel’s stellar double-digit EVA Margin figures. On a more positive note, AMD’s market share gain across its various segments translated to an inflection point in shareholder value creation by the end of 2019. Looking ahead, the company’s EVA Margin is expected to stabilize in the positive (5-10%) territory for years to come. That being said, it is too early to tell whether AMD can set foot among its giant rivals, thus at this stage, it is impossible to assign any quantitative moat rating to the company (although the EVA Margin trend is remarkably positive, thus our judgment might get revised in the coming years).

48383446-16030235558759859.pngSource: evaexpress.com

Assessing incremental EVA returns

EVA Momentum measures the growth rate in EVA, scaled to the size of the business (measured by its sales). It is the EVA framework’s equivalent for Return On Incremental Invested Capital or ROIIC. Any positive EVA Momentum is good because it means EVA has increased, and it is an indication that it is worthwhile to reinvest capital in the underlying business. Instead of pinpointing any single-year performance, we prefer to look at the long-term trailing averages in EVA Momentum.

48383446-16030236452910194.pngSource: Author’s calculation based on data from evaexpress.com

Over the past decade, AMD has generated an average EVA Momentum of 2.4%, although it is worth mentioning that this performance can almost entirely be attributed to the improvement in EVA Margin levels as top-line performance remained underwhelming up until recently. To put that into perspective, the long-run average for the 75th percentile of the U.S. stock market (represented by the Russell 3000) is 1.0-1.5% percent, while it is also important to note that AMD started off with a substantially negative EVA base. That said, the stellar EVA Momentum is a clear indication that the company is on the right track to move towards sustained value creation.

Our take on the moat

The EVA framework enabled us so far to prove from a rearview-mirror perspective, whether the company has an economic moat based on its historical consistency of shareholder value creation. From a qualitative standpoint, AMD lacks both the necessary scale and massive R&D budgets of the likes of Intel and Nvidia, leading to the debatable sustainability of its competitive position.

Although the fact that AMD does not possess its own manufacturing operations helps to reduce the level of invested capital (thus increasing EVA), it also comes as a downside, since the company extensively relies on external foundries like Taiwan Semiconductor Manufacturing Company (TSMC) and GlobalFoundries for its chip production. Especially in the case of TSMC, the competition is heating up for allocation of its production capacity, where AMD is running yet again against Nvidia and even Intel, after the latter’s newfound openness for outsourcing was announced earlier this year. Furthermore, although the company is certainly better positioned in terms of product portfolio than a decade ago, it remains to be seen whether it can sustain positive economic profits over an extended period, thus we argue that currently a no-moat rating seems warranted for AMD from a qualitative standpoint.

Taking a brief snapshot at the company’s debt profile, AMD has an investment-grade S&P Credit Rating of BB+ coupled with a long-term debt to capital ratio of 16%. It is worth noting, that although the company’s gross margin expansion and newfound free cash flow generation capability would likely strengthen AMD’s credit rating, the recently surfaced interest in acquiring Xilinx might weigh on the metric in the years ahead.

Summary of operations - the Quality Score

The EVA framework’s Quality Score is a comprehensive way to assess a company’s overall quality, by combining its EVA-based Performance (EVA Margin and Trend) and Risk (e.g. Volatility and Vulnerability) metrics into a single score, measured against the broader market. In the case of extraordinary companies, we would like to see a Quality Score consistently above 80 over a long period. As outlined in our research article, the upper quintile tends to outperform the market historically.

In the case of AMD, the company’s Quality Score has been all over the place within the past 15 years, as the lack of economic value creation clearly weighed on the metric up until recently. The trend, however, is reassuring, showcasing the positive effect of the initiatives detailed above. Based on AMD’s market share gains and profitability improvement, we expect the company’s Quality Score to stabilize within the 60-80 range. It is worth noting though, that the potential Xilinx deal might pose a risk to the current financial stability of AMD, which could result in increased pressure on the company’s Risk Score going forward.

48383446-16030237671367853.pngSource: evaexpress.com

As a final assessment, AMD’s encouraging turnaround achievements seem to indicate the beginning of a promising era, which could manifest in a double-digit EVA Margin and meaningful EVA Momentum going forward. We must note, however, that AMD’s non-existent moat is certainly alarming, thus we are having a hard time to give the company a pass rating based on our rigorous criteria.

Capital Allocation

After looking at the operations dimension, we continue investigating the company through the capital allocation lens. Remember, the incremental return on invested capital (measured by EVA Momentum) is a crucial element when it comes to the assessment of successful capital allocation by management. If the company can earn a positive EVA by reinvesting all the cash generated by the underlying business, shareholders are better off if the firm retains most of its earnings. In the table below, we have dissected all the possible uses of cash for AMD for the past decade.

48383446-1603023846836128.pngSource: Morningstar

As outlined earlier, AMD had negative operating cash flows up until 2015, which makes looking at the capital reinvestment rate in those years meaningless. With respect to the numbers from the past few years, we can say that AMD reinvests relatively modest levels of capital, although it is very hard to make a judgment because of the short time horizon. That being said, the semiconductor industry tends to be fairly capital-intensive in general, while significant R&D expenses (23% of sales in 2019 in case of AMD) are also necessary for companies to keep their competitive position. In such a research-intensive business, the EVA Framework gives a more realistic picture over the standard GAAP accounting, by capitalizing R&D spending and amortizing it over 5 years, rather than immediately expensing it. The correction of such accounting distortions gives a definite edge to this framework over conventional standards.

With AMD’s EVA Momentum coming in at 2.4% in the last 10 years, the current level of reinvestment seems justified, since it translated to shareholder value creation in the most recent year, even though the company only managed to achieve a slightly positive EVA. Despite this, EVA Momentum measures performance progress. EVA puts a firm that is turning around and making a negative EVA less negative on the same scale as one that is already wildly profitable and adding to its economic profit. The current management team, led by Lisa Su, deserves to be commended for this achievement, while they also did a solid job in driving a more focused long-term plan for AMD. The main capital allocation priority in previous years was about deleveraging and strengthening the balance sheet for the future:

“I do remember the days when we had the challenge on the balance sheet. And one thing we feel good [about] as we end 2019 is the strength of the balance sheet, and in particular, the net cash position.”

Source: Devinder Kumar, CFO, Q4 2019 Earnings Call

Since AMD began producing positive FCF only recently, there was no available cash that could have been distributed to shareholders, thus the company did not buy back any shares or paid a dividend.

Acquisitions

There was no meaningful acquisition that is worth mentioning in AMD’s past, the only interesting piece is AMD’s possible takeover of FPGA chipmaker, Xilinx. This potential combination could make sense from a strategic perspective for AMD, as the deal would extend the company’s product portfolio to help drive sustainable growth while also diversifying the company’s revenue streams. Xilinx shows the traits of a great business, with its EVA Margin averaging 21.4% in the last 5 years, a feat only the best companies can achieve. Its key end markets consist of automotive, data centers, and 5G infrastructure, all of which could help AMD to extend its reach beyond the PC and server CPU market.

That being said, the transaction could value the target at nearly billion, which would be a very significant amount for AMD. On the upside, it would make sense if the deal would be financed mostly with AMD’s grossly overvalued stock, as paying with an overvalued currency could be value-accretive for AMD’s shareholders. Nonetheless, there are always significant integration risks with acquisitions of this magnitude. For example, since the FPGA business is extremely support-intensive, perhaps the most valuable human resources in an FPGA company are the field applications engineers (FAEs). Retaining, maintaining, and managing such an asset through an acquisition is always extremely challenging, and failing to do so could have serious ramifications for the combined company’s customers.

Despite the strategic rationale, the valuation of Xilinx seems rather steep to us, so it remains questionable whether this potential takeover would ultimately create enough synergies for it to be EVA positive at this elevated purchase price.

Valuation

Future Growth Reliance

Our prime historical valuation indicator in the EVA world is the Future Growth Reliance (FGR), which is the percent proportion of the firm’s market value that is derived from, and depends on, growth in EVA. As outlined in our research article, it is the best-of-breed sentiment indicator that addresses accounting distortions, thus gives us a true picture of which companies seem attractively valued in historical terms.

48383446-16030240128963804.pngSource: evaexpress.com

Looking at the chart of AMD, it becomes readily apparent how the market continues to have high expectations regarding the company’s future EVA generating capability. While we tend to look at long-term average FGR figures as a sentiment indicator, it makes less sense in the case of AMD, as the metric is skewed by the highly volatile (and negative) EVA figures of the past. It is important to note though, that despite the newfound positive EVA generation capability, the FGR metric remained at exuberant levels. Numerically, it is standing at 86% as of October 16, which means that ~86% of AMD’s market cap is derived from expectations for future growth. To showcase how utterly exaggerated the current sentiment is regarding the company’s future EVA growth potential, we ran an enterprising scenario through our discounted EVA model, assuming an Intel-like 10% EVA Margin coupled with an EVA growth of 15% annually for the next 10 years. The resulting valuation for AMD’s shares is fundamentally disconnected from today's extravagant price of .17, turning AMD into not much more than a reckless bet at today’s levels.

Morningstar DCF

As a second step, we use Morningstar’s valuation system, where analysts create industry and company-specific assumptions, and then all the inputs are used in a discounted cash flow model. In order to reflect all moving parts within the business, the analyst firm also evaluates the level of uncertainty with all the stocks they cover. Morningstar assigns AMD a very high uncertainty rating with a fair value. The thresholds between the different star ratings are illustrated below:

48383446-16030241664784427.pngSource: Author’s illustration based on Morningstar data

With the stock currently trading at .17 as of October 16, a 1-star rating is warranted, implying that AMD’s shares are egregiously overvalued based on Morningstar's estimate, in line with our previous analysis relying on EVA fundamentals. It is worth noting, that our EVA-based optimistic fair value estimate falls almost exactly in line with Morningstar’s assessment. No matter from which angle we look at it, AMD’s shares trade at exuberant levels today.

Summary of the investment thesis

PRVit score - heat map vs. market

After all our due diligence, we turn to the PRVit model for a final judgment of the overall attractiveness of a stock. The PRVit is a multifactor quantitative stock selection model based on EVA-centric measures of Performance, Risk, and Valuation. Combining a company's Quality Score with its actual Valuation Score can be visualized on a heat map like the one below, where the gradient diagonal line signals fair value. We want to see a stock in the upper-right hand corner of this heat map, but we are more concerned with the Quality Score, as we believe that over the long-run, we are better off with a truly exceptional business bought at a fair price, rather than a fair company bought at an exceptionally attractive price.

48383446-16030242874099042.pngSource: evaexpress.com

As visible on the above heat map, although AMD’s current Quality Score is just a little shy of Intel’s (resting heavily on its positive EVA Momentum figures), the stark valuation contrast between the two is readily apparent. As opposed to the grotesque overvaluation of AMD, Intel remains our preferred pick in the microprocessor space, as outlined in our prior article. Considering the optimistic assumptions behind our fair value estimate for AMD, only a sharp drop into the - range would start to raise our appetite for this company, as we would require a significant margin of safety to make up for the fact that AMD’s value is almost entirely derived from the immense growth expectations (which may or may not materialize in light of the profoundly competitive environment) and the lack of an enduring moat around the business. It is important to note though, that even at such depressed levels, our most conservative analyst wouldn’t touch AMD with a ten-foot pole due to his pronounced focus on quality. Not to mention today’s nosebleed heights, from where (however hard we tried) it was impossible to come up with a positive(!) total return potential over the next 5 years, even if EVA grows eightfold in that timeframe. Investors who are eager to jump on the “growth-at-any-price” bandwagon today might end up with a sobering lesson.

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