Chip stocks have been in a bloodbath lately given their highly cyclical nature. Economic challenges brewing ahead, such as searing inflation data and rising geopolitical tensions, further fuel the sell-off. The NASDAQ 100 index has undergone a correction of more than 26% since the beginning of the year. Against this general backdrop, all major chip stocks suffered far worse losses, as seen. Namely, Intel (INTC) fell more than 41% and, ironically, is the “best performing” major chip stock of the past year. NVIDIA (NVDA) suffered a 55.3% loss, which will require a 123% recovery to break even.
And today’s main topic, Advanced Micro Devices, Inc. (NASDAQ: AMD) suffered a loss of more than 46%. The combination of such a price correction and earnings growth has now taken AMD’s P/E FW to around 17.6x (less than half of NVDA’s 38x P/E FW). As you can see from the chart below, this is the lowest level since 2021, and also a very attractive multi-year level. The valuation is further compressed when adjusted for its growth potential. As you will see in a later section, its P/E/Growth (“PEG”) ratio is down to just 0.57x, and a simple reality check will show a very skewed return profile over the next few years. .
On the other hand, the fundamentals of companies remain solid. AMD currently provides the best product line not only in its own history, but also arguably in the industry. As explained below, I see both the Zen4 processor and the Xilinx Synergy as key drivers to unlocking its next growth cycle. They will further bolster its already strong product lines, expand its moat and maintain its pricing power for years to come.
Xilinx and Zen4 further strengthen the product line
AMD currently offers the best product portfolio not only in its own history, but also arguably in the industry. These products include a rich mix of lines such as EPYG server processors, high-end Ryzen processors and high-end game consoles. These products successfully address critical high-growth market sectors, including desktop and mobile computing, PC and gaming, GPUs, data centers, and more. As a result, many segments are showing robust growth. Take the example of the Computing & Graphics and Enterprise, Embedded & Semi-Custom segments. Both offer some of the most advanced products and had posted a high double-digit annual pace in the March quarter.
Admittedly, the company reported headwinds in the June quarter. Growth has slowed and margins are under pressure (as we will see in the next section). However, I consider these issues to be temporary and part of the normal business cycle. Products are what ultimately matters at a fundamental level. And I view both its acquisition of Xilinx and Zen4 as further strengthening its already strong product portfolio. AMD completed the acquisition of Xilinx for $35 billion in mid-February, and it has already added to existing deals. It added nearly $560 million to revenue in the short period following its acquisition. And the potential synergistic benefits are just beginning in areas like AI, as CEO Lisa Su commented in the Q2 earnings release (abbreviated and underlined by me):
… we have identified more than $10 billion in long-term revenue synergy opportunities as we bring together the assets of AMD and Xilinx. Our biggest opportunity is in AI and we have already started executing new hardware and software roadmaps to seize the significant opportunity we see to drive pervasive AI across cloud, edge and endpoints.
At the same time, the launch of the long-awaited Zen4 processors is on track, as Dr. Lisa Su also commented in the Q2 earnings release (abbreviated and underlined by me):
…we are well on our way to launching our brand new 5 nanometer Ryzen 7000 desktop processors and AM5 platforms later this quarter, with leadership performance in games and content creation. Looking back, although the PC market has experienced further downturn in recent months, we believe we are very well positioned to navigate the current environment due to the strength of our existing product portfolio and the launches of upcoming products.
These new Zen4 chips are expected to compete with Intel’s Raptor Lake series. The chips deliver the “six fives,” features highly anticipated by high-end users like content generators and gamers: DDR5, PCIe 5.0, 5nm, AM5 memory and 5.5GHz+ clock speed. The 16-core Ryzen 9 7950X is the flagship of the new series. AMD says it’s the fastest processor in the world and will come at a premium price of $699, which will help further boost AMD’s margin and growth, as detailed below.
Headwinds and Margin Pressures
As mentioned above, the company reported headwinds in the June quarter. Growth is expected to slow in the coming quarters and margins are under pressure. On a GAAP basis, first quarter 2022 gross margin was 48%, 200 basis points below the record 50% set in fourth quarter 2021. And second quarter 2022 gross margin contracted by An additional 200 basis points to reach 46%, as shown below.
To put such pressure into a broader perspective, the following graph compares AMD’s gross margin in recent years to NVDA and INTC. As can be seen, there is little doubt that the entire chip sector is currently going through a contraction phase of the cycle. All of the major stocks have seen significant margin compression. NVDA suffered the most, with margin plunging from a peak of nearly 65% in the prior quarter to the current level of 43%. AMD’s margin suffered the least. And its current margin of 46% is still above its long-term average of 42.75% and also above both NVDA and INTC.
Going forward, I see both the Zen4 version and the Xilinx Synergy to help maintain its margin advantage. As mentioned, I expect Zen4’s top performance and premium pricing to create headwinds on the margins. I also expect the Xilinx Synergy to add scale and scalability and improve overall cost absorption. During the March quarter, cost of goods sold decreased 180 basis points as a percentage of total revenue due to better cost absorption.
Reality Check and Projected Returns
Based on the above valuation comparison and company fundamentals, the following chart shows a summary calculation of projected returns over the next 5 years. This is what I call a reality check or common sense test. This is an estimate of the growth rate needed to achieve a target return on investment over the next five years. In particular, the light blue horizontal lines mark the growth rate and valuation needed to provide a 10% annual return (1.1^5 = 160%).
The red line shows the returns if the valuation remains constant at the current levels of 17.2x P/E. The blue line shows if the P/E increases in the next 5 years at 20x. And finally, the green line shows the scenario of a P/E contraction at 15x. Under these assumptions, the purple box shows where I think the most likely return scenarios would be. As can be seen, AMD is expected to provide an annual return of between 7.1% and 24%, assuming a growth rate of between 10% and 15%.
And as you can see on the 2n/a chart below, consensus estimates call for a CAGR of 17% over the next few years. Thus, the assumption of a growth rate between 10% and 15% represents a conservative projection.
Risks and Final Thoughts
Besides the pressure on margins mentioned above, AMD also faces other risks. As a highly cyclical stock, the projected growth rate could contain large uncertainties. These uncertainties are encapsulated in the large variance of consensus forecasts, as noted above. The gap between the optimistic and pessimistic forecasts is more than a factor of 1.5x for FY2024 for example (EPS of $5.0 on the low to $7.52 on the high). In terms of annual rate, the low estimate projects a CAGR of 11% by 2025 (from EPS of $4.37 in 2022 to $6.05 in 2025), and the high end estimate projects a CAGR of by 21% (from EPS of $4.37 in 2022 to $7.67 in 2025). Although, as described in my simple reality check, even a conservative assumption of a 10% to 15% growth rate could lead to solid returns.
To conclude, chip stocks are notoriously cyclical and AMD is no exception. And there is no doubt that we are going through a contraction phase of the cycle. The stock has lost more than 46% over the past year and more than 9% in a single day on September 13. Such large corrections, combined with sound fundamentals, have created a high asymmetric risk/reward profile. Under current conditions, an annual return of more than 20% is likely, even under conservative growth scenarios. And the decline is limited even if the valuation still contracts.
Finally, the stock also has a solid balance sheet, key to survival in a highly cyclical sector. As shown in the chart below, AMD currently has approximately $5.99 billion in cash on its ledger, which translates to $3.08 per share. It has some debt ($3.2 billion), but the debt is less than the cash position. As a result, it holds a net cash position, a whopping $2.8 billion, in the ledger. When we subtract silver from the stock price, its PE would become even lower (slightly though, by around 1.8%). Finally, as you can see from the following comparison, AMD has the strongest balance sheet among its peers in terms of debt ratio (only 5.8%) and debt to total capital ratio (only 4 .9%).