Sept 27 2021 - AMD And Intel Offer Similar Returns - Focus On The Risks

Summary

• Semiconductor stocks benefit from long-term tailwinds, but steep returns are not guaranteed.
• INTC and AMD will deliver high-single-digits returns in the coming years, I believe, but due to different reasons.
• The two companies come with different risks, and investors may want to decide what type of risk they are willing to take on.

Article Thesis

Despite big differences, Advanced Micro Devices (NASDAQ:AMD) and Intel (NASDAQ:INTC) do, according to my models, surprisingly offer a relatively similar return outlook, in the high-single-digits, over the coming years.

I do hence believe that it may make more sense to focus on the two companies' unique sets of risks when deciding between these stocks. Investors have to consider whether they do feel better being exposed to Intel's execution risk, or whether they want to go with AMD, where valuation depression and its reliance on foundries are the key risks factors.

Total Return Forecast

Investors naturally are interested in generating returns from their investments, thus let's try to forecast what returns could look like through 2025. AMD is forecasted to generate EPS of .50 this year, and analysts expect that this amount will climb at an attractive double-digit rate, which gets us to a 2025 EPS estimate of .65.

Right now, AMD trades for more than 40x its net profit, but this will likely change over the years, due to two reasons. First, AMD has traded at lower valuations in the past, and second, companies that grow in size do usually see their growth rate slowdown, which justifies multiple compression over the years. As we can see in the following chart, shares averaged a P/E multiple in the high 30s over the last year, versus a 41x forward earnings multiple today.

Considering the aforementioned multiple compression as AMD matures, I believe that one could assign a fair value multiple of 25 for 2025 -- this would still represent a huge premium over lower-growth peers such as Intel but would, at the same time, seem more reasonable for a more mature AMD. The target price for 2025, in this scenario, is 1, representing an upside potential of close to 40%, which gets us to an annual return of roughly 8% -- attractive, but not outstanding.

Intel, meanwhile, is forecasted to generate EPS of .80 this year. Analysts are predicting relatively uneven EPS performance over the coming years, which may very well come true. If Intel grows its EPS by just 2% a year, which seems like a very much achievable goal thanks to inflation, growing global chip demand, and due to the fact that Intel's foundry business should start to have an impact by 2025, then we get to an EPS target of around .20. Today, INTC trades at just 11x forward earnings, but that is a rather low valuation both in absolute terms and relative to how shares were valued in the past. The median earnings multiple over the last five years is 13.3, which seems like an appropriate target valuation, which, in turn, gets us to a price target of . Relative to Intel's current share price, this would allow for annual share price gains of 6.5%. Add in a 2.5%-yielding dividend, and Intel could generate 9% annual returns, even with a pretty slim earnings growth rate. In this scenario analysis, Intel thus looks like the slightly better pick, but one can, of course, argue that inputs should be different.

Balance Sheet And Shareholder Returns

Intel offers a dividend yielding 2.5% at current prices, which is roughly twice the yield of the broad market. AMD, on the other hand, does not offer any dividend payments for now. This isn't a large surprise, however, as AMD has not been generating meaningful free cash flows over the more recent past, and was thus not really in a position to offer any generous payments. Intel, meanwhile, due to its way stronger free cash generation, was not only able to raise its dividend regularly, but on top of that, Intel has been paying out billions in cash via share repurchases. Over the last three years alone, Intel's share count dropped by 11%, while AMD's share count has risen by more than 20% in the same time frame:

This is the result of share issuance in AMD's case, e.g. to retain talent and pay executives, while Intel's declining share count can be explained by its buyback programs working in favor of shareholders. Share count dilution at AMD has not been a major issue in the past, as shareholders still benefited from very sizeable returns, but in case AMD continues to dilute shareholders rapidly in the future, returns may take a hit from that.

AMD has a pretty clean balance sheet, with .7 billion in cash outstripping its long-term debt. Relative to its market cap of well above 0 billion, its net cash position isn't especially meaningful, however. Intel, meanwhile, has an billion cash position, but also holds a billion debt position (short- and long-term debt combined), according to its 10-Q. AMD thus has the better balance sheet today, but this came at the cost of issuing shares repeatedly and avoiding shareholder return programs.

What Risks Do You Want To Take On?

Intel slightly beats AMD's returns in my model, but since there are no major differences in forecasted total returns, investors may want to base their investment decisions on other things, such as the risks of investing in these stocks.

Intel's strategy involves expanding its footprint in the US, which would help in shielding the company from trouble in future trade wars, while at the same time, this provides some hedges against Taiwan-related geopolitical risks. With the administration in favor of onshoring chip production, Intel may benefit from favorable politics and subsidies with these endeavors. Intel seeks to become a major player in foundries through IFS -- when we look at TSM we see that this can be a highly profitable business model when done right. IFS, which is growing from zero today, does have a very solid outlook and could accelerate Intel's overall growth meaningfully in the coming years. Its US footprint could come in handy if tensions between Taiwan and the US rise, as this may lead to customers favoring Intel's production over peers, while at the same time, Intel could be seen as a safe haven by investors, which may lead to multiple expansion tailwinds in such a situation.

Geopolitics is thus not a key issue when investing in Intel. Instead, I believe that execution is the main risk. The company has a huge market share, strong cash flows, and trades very inexpensively, but its main problem is its inability to execute well when it comes to the introduction of new process types, which allows peers such as AMD or NVIDIA to gain market share. This does not only hold true for its 7nm chip delay but the company also had to delay the newest version of its Xeon server chips this summer. Thanks to swapping its CEO to a more tech-focused/engineering-focused CEO, Pat Gelsinger, earlier this year, it seems likely that Intel will get better at bringing new products to the market in a timely manner. Still, this is Intel's core problem and will likely remain the core risk going forward.

AMD, on the other hand, has been great at execution, and this doesn't seem to be a major risk for the company. There are, however, two other risk factors investors should not ignore. The first one is valuation risk -- AMD trades at a quite elevated valuation of more than 40x net profits, and this could change due to a range of factors. If, for example, interest rates climb, highly-valued growth companies such as AMD would be more exposed to multiple compression than value stocks such as Intel. If global chip demand growth slows down and AMD grows its EPS less than expected, its multiples could also decline considerably. Intel is more insulated from that, as not a lot of growth is priced in anyways. If AMD's shares were to trade down to 30x net profits, all else equal, its shares would drop by more than 25%, and since shares traded in the s just a couple of months ago, this does not seem extremely unlikely.

Another important risk is AMD's reliance on foundries such as TSM. This does not only make AMD vulnerable versus a potential China-Taiwan conflict (which is why I believe that geopolitical risks are more pronounced at AMD), but it also means that it is in a weak negotiating position should TSM ever decide to demand a bigger portion of the overall pie. In that case, AMD's margins could compress, which, in turn, could pressure EPS growth and its valuation.

In some sense, investors have to decide whether they want to go with a company that has low execution risk but significant valuation downside and that is more exposed to geopolitical risks, or whether they want to go with a stock that is pretty inexpensive and has low valuation downside, but where execution may turn out to be a hindrance for future returns.

I do favor Intel slightly among these two, and it is part of my buy-and-hold portfolio, but I do not at all want to imply that AMD is a bad company. Quite the contrary, we released a bullish article on AMD in June, with shares delivering 30% since then. Due to the valuation expansion since then, buying now seems like a less favorable idea, however.

Is This an Income Stream Which Induces Fear?