AMD Seems Set For Many Years Of Growth (NASDAQ:AMD)

AMD Seems Set For Many Years Of Growth (NASDAQ:AMD)

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Investment thesis

Advanced Micro Devices, Inc. (NASDAQ:AMD) has invested aggressively to gain access to huge market opportunities in data centers and cloud computing while continuing to be a technology leader in the graphics and gaming segment. Although the company has seen its market share in CPUs falling over the last few quarters, its upcoming Ryzen 7000 desktop chips have the potential to significantly boost its revenue. The company has a very promising product pipeline, and its combined roadmap, together with the recent acquisitions, suggests that AMD has now set important milestones to massively increase its market share in multiple strong secular markets. My rather conservative valuation model prices the stock’s fair value at $123.06, with a 25.46% upside potential from its last closing price.

A quick look at AMD

Advanced Micro Devices is an American information technology and semiconductor company that operates through four segments, which reflect its strategic end markets: Data Center; Embedded; Client; and Gaming. The Data Center segment includes AMD EPYC server Central Processing Units (CPU), AMD Radeon Instinct data center Graphics Processing Unit (GPU), and adaptable acceleration solutions for data centers. The Embedded business segment includes Field Programmable Gate Arrays (FPGAs), Adaptive System-on-Chip (SoCs) for system optimization with scalable processor integration. The Client segment offers CPUs in the traditional desktop and notebook PC business under the brands AMD Ryzen, AMD Ryzen Pro, and AMD Threadripper. The Gaming business segment includes the Discrete Graphics Processing Units (dGPU) business under the brand AMD Radeon and AMD Radeon Pro, and the semi-custom game console business based on RDNA Architecture.

The company was incorporated in 1969, is headquartered in Santa Clara, California, and employs about 15,500 employees worldwide. Its most important geographical regions by sales are the United States, followed by China, Japan, Taiwan, Singapore, and Europe.

AMD recently finalized the acquisition of Xilinx and the acquisition of Pensando Systems, two transactions valued at $49B and $1.9B, respectively. They have products and technologies that complete AMD’s product portfolio and allow more diversified revenue streams from different industries, especially in the data center segment. In Q2 2022, AMD significantly grew its revenue, mostly boosted by sales of its EPYC processors, its Ryzen mobile processors, increased semi-custom sales, and the revenue stream from the inclusion of the Xilinx embedded solutions.

AMD

The company’s success relies on multiple secular growth drivers with huge market opportunities. While the total addressable market (TAM) for the company in 2020 was still estimated at $79B, the actual value has increased by over 70%, and the projections over the next five years reached $300B, with data centers forecasted to offer the biggest market opportunity.

AMD

What’s up next for AMD?

AMD is focusing its strategy on heterogeneous adaptive computing solutions. With its chiplets integration technology, the company seems to be consistently able to offer a highly efficient chip architecture in terms of area, power consumption, and increased performance per watt:

From the cloud and PCs to communications and intelligent endpoints, AMD’s high-performance and adaptive computing solutions play an increasingly larger role in shaping the capabilities of nearly every service and product defining the future of computing today.

Dr. Lisa Su, CEO of AMD

AMD’s Ryzen 7000 desktop chips are expected to be launched in the short term. Speculation is that it could be launched as soon as at the “Meet the Experts” event on August 5th and would be the world’s first 5nm x86 CPUs, offering significant performance and efficiency increase through the company’s proprietary Zen 4 microarchitecture when compared to the previous generation. The Zen 5 CPUs are planned for 2024 and will be focusing on artificial intelligence (AI) and machine learning (ML) applications. While the company’s main focus will stay on the launch of the Ryzen 7000 CPU, the company is also expected to launch its 6nm Mendocino chip for budget and mainstream laptops in the coming months. By 2023 the Phoenix Point mobile processor is planned to integrate AMD Zen 4 core architecture, AMD RDNA 3 graphics architecture and Artificial Intelligence Engine (AIE), followed by the Strix Point processor planned for 2024.

AMD

The global data center chip market reached a value of $9.56B in 2021 and is expected to grow at a 6.70% Compound Annual Growth Rate (CAGR) through 2027, reaching a value of $14.11B. The global data center accelerator market was valued at $13.7B in 2021 and is forecasted to grow at 31.06% CAGR through 2027 and reach a size of $69.44B. AMD plans to grow in large part through data center chips, and although the company is still underrepresented in the industry when compared to its main competitors, and NVIDIA (NVDA) is very aggressively penetrating that market segment, the acquisitions of Xilinx and Pensando give the company an edge in High-Performance Computing (HPC), accelerated computing, and adaptable solutions.

Xilinx’s solutions are already widely used in hyperscale data centers by global operators such as Alibaba (BABA, OTCPK:BABAF), Amazon (AMZN), IBM (IBM), Microsoft (MSFT), and Tencent (OTCPK:TCEHY, OTCPK:TCTZF), and the market is expected to grow at 26.32% CAGR through 2027. The acquisition of Pensando will instead allow AMD to offer and integrate AI acceleration hardware, as the company is trailing its rivals NVIDIA and Intel (INTC) in that segment. While NVIDIA, Intel, and even smaller competitor Marvell Technology (MRVL) all offer Data Processing Units (DPUs), and those new programmable processors are increasingly becoming important in data centers and networking, AMD needed to catch up.

The GPU market was valued at $23.90B in 2021, and it is expected to reach a value of $130.02B by 2027, with a forecasted CAGR of 32.70%. Meta Platforms (META), which is building the world’s largest AI supercomputer to power the Metaverse, and sources its chips from AMD and competitor NVIDIA, could dramatically increase its investment in GPUs, as it faces strong competition from rival TikTok. AMD RDNA 3-based Navi 3X products are expected to launch later this year, with an estimated 50% uplift in performance per watt, compared to the RDNA 2 architecture.

AMD

The company is now strategically positioned to gain market shares in the 5G wireless infrastructure market, as already Xilinx supplies major wireless equipment manufacturers, such as Cisco Systems (CSCO), Fujitsu (OTCPK:FJTSF, OTCPK:FJTSY), Nokia (NOK), and Samsung (OTCPK:SSNLF, OTCPK:SSNNF), with the global 5G infrastructure market forecasted to expand at 71% CAGR through 2027 and reach a valuation of over $80B. Last but not least, another key growth area could come from Xilinx sales in the automotive industry, as its chips are used by larger manufacturers for their infotainment systems, automated parking, and advanced driver-assistance systems (ADAS), and external sensors and cameras for self-driving applications.

An insight into the industry

The company reported an increasing gross margin, accelerating from 43.70% CAGR over the past 5 years to 56.30% CAGR over the past 3 years and standing at 50.80% Trailing Twelve Months (TTM), outperforming the average gross margin of the analyzed peer which stands at 58.14%. While Broadcom (AVGO) reported the highest gross margin, AMD and NVIDIA could achieve the highest growth rates during the last years. In my article Nvidia Is The Stock Every Investor Should Consider, I present an in-depth analysis of this high-performing company. In terms of operating profitability, AMD reported a stunning improvement of 95.55% CAGR over the past 5 years, growing 79.21% CAGR over the past 3 years, but the last quarter saw its operating margin contracting by 25.30%, establishing its margin at 16.83% TTM, significantly under its long-term margin target in the mid-30s%. The last time the company saw its operating margin contracting was in Q1 and Q2 2019.

Author

In terms of capital allocation efficiency, AMD saw its Return on Invested Capital (ROIC) and its Return on Capital Employed (ROCE) significantly drop in the last 12 months to only 6.02% and 5.86% respectively. Those are two metrics I particularly observe when pondering an investment decision, as a company must be able to consistently create value to be a sustainable investment. AMD’s capital allocation efficiency was significantly impacted by the completed acquisition of Xilinx and Pensando, as well as by the $2.5B debt that the company took on in the last two quarters. AMD could improve its capital efficiency, especially when considering that before the recent events, its ROIC stood at 67.89% in 2021 and 65.29% in 2020, the highest values recorded among the analyzed peers.

It’s worth mentioning that NVIDIA and Texas Instruments (TXN) have consistently reported significantly high ROIC compared to the peer group in the past 5 years and that both companies could even improve their capital allocation efficiency by employing their large idling cash positions, as the spread between their ROIC and ROCE suggests. Analog Devices (ADI) is instead consistently lagging behind the peer group when considering its ROIC.

Investments in Research and Development (R&D) are of primary importance for companies in the semiconductor and technology industry, AMD is spending a relatively fair amount of 18.24% when compared to the average of its competitors at 16.81%. The company reported the lowest leverage of 0.44, with Broadcom reporting the highest debt exposure.

Considering the stock performance of the past 5 years, AMD had a stellar performance compared to the analyzed peers, almost doubling the already significant performance of its competitor NVIDIA. Intel is the worst performer in the group, as the company could not convince in terms of innovation and returns for investors.

Author, using SeekingAlpha.com

Without surprise, AMD outperformed significantly the VanEck Vectors Semiconductor ETF (SMH), as well as both the QQQ (QQQ) and the S&P500 in the last four years while only showing some relative weakness during 2017 and 2018.

Author, using SeekingAlpha.com

AMD has proven to be consistently a technology leader and offers innovative and competitive solutions across its product portfolio. The company’s strong positioning in secular growth markets, its relative strength compared to its reference indexes and peers, as well as its ambitious roadmap, are elements that could likely continue to contribute to the outperformance of its stock, with high potential returns for investors.

Valuation

To determine the actual fair value for AMD’s stock price, I rely on the following Discounted Cash Flow (DCF) model. It extends over a forecast period of 5 years with 3 different sets of assumptions ranging from a more conservative to a more optimistic scenario, based on the metrics determining the Weighted Average Cost of Capital (WACC) and the terminal value. As forecasted by the Street consensus, the company is anticipated to generate a consistent, solid 19.94% Free Cash Flow (FCF) CAGR over the coming 5 years, with substantially increased net profitability at 28.27% CAGR, while its revenue is forecasted to grow slower, at 10.94% CAGR.

Author, using data from S&P Capital IQ

The valuation takes into account a tighter monetary policy, which will undeniably be a reality in many economies worldwide in the coming years and lead to a higher weighted average cost of capital.

Author

I compute my opinion in terms of likelihood of the three different scenarios, and I, therefore, consider the stock to be considerably undervalued with a weighted average price target with 25.46% upside potential at $123.06. Investors should consider that those forecasts are based on relatively higher discount rates and the recent trend in increased interest rates, which reflects the actual situation and forecast possible scenarios. An inversion of this trend would change this perspective and value the company at a significantly higher price.

Risk discussion

As great market opportunities attract great competitors, AMD faces strong competition from well-established and innovative companies. Intel is by far the worldwide market leader in x86 CPUs with a 63.55% market share while AMD reaches 36.40%. If considering only laptop CPUs, Intels’ leadership is even more evident, with a 73.70% market share. Intel’s 12th generation Alder Lake CPU has been selling well until now in both desktop and laptop computers, and could further erode AMD’s market share.

PassMark

Despite Intel never confirming itself in the dGPU market segment, the company is the leading GPU manufacturer with about 60% market share thanks to its integrated Graphics Processing Units (iGPU), followed by NVIDIA and AMD with respectively 21% and 19%. Intel can also leverage its strong position in server chips and its tight relationship with major actors in the global industry, but lately, it struggles with delays and breakthrough innovation capacity. NVIDIA counts more than 200M gamers using its GeForce technology and is the global leader for dGPU with a market share of 78% in Q1 2022, followed by AMD with a market share of 17%. Apple with its high-performing ARM-based chips series has set a new benchmark in the CPU industry, and despite the fact the company is apparently not planning to sell its chips to other manufacturers, this has never been officially confirmed and the company’s strategy could change in the future.

Samsung announced the world’s first 3nm chip with supposedly a 16% decrease in surface area, 23% higher performance and 45% lower power consumption compared with current 5nm chips. AMD and competitor NVIDIA have greatly profited from the huge increase in GPU demand used in the mining process of cryptocurrencies in the past years; the ongoing longer crypto-winter could further negatively impact the pricing power and revenue as the market looks saturated with second-hand, lower-priced graphics cards. AMD is not manufacturing its chips and relies on third-party foundries located outside of the United States, like Taiwan Semiconductor Manufacturing Company (TSM). This exposes the company to substantial risks in terms of price fluctuations, geo-political risks, and manufacturing capacities.

The Covid-19 pandemic has significantly impacted the whole industry in terms of workforce, increased air- and ship-freight costs, and supply-chain bottlenecks, causing shortages, delays, and increased pricing pressure. The ongoing war in Ukraine added inflationary pressure on rare earth and metals, and shortages of neon gas, an inevitable component in the manufacture of semiconductors. Although the company could manage some of those negative factors, extended geopolitical tensions like those building up in the South China Sea, or an extended war in Europe, could significantly impact the company’s opportunities in the coming years.

Market timing

The stock reached its ATH (All-Time-High) at $164.46 on November 30, 2021, after a sustained rally since the Covid-19 pandemic low at $36.75 on March 18, 2020. The stock successively retraced a significant part of its previous gains, by mostly underperforming the NASDAQ Composite, a very similar pattern to some of the company’s peers, as many companies in the technology sector lost massively in value since the beginning of 2022. From a technical analysis point of view, the stock recently rebounded significantly at $71.60, close to a strong-midterm support level, by overcoming the most important short-term resistances and confirming its price level over the EMA50 and the EMA100 with increasing volume.

This is an ideal setup for swing and momentum traders. The stock successively tested the EMA200 on August 2, but couldn’t overcome it in that session. The coming market sessions will show if the EMA200 can be overcome and act as a support, or if the stock will retrace further its gains and continue its downtrend, as this price level also faces another important resistance level at $100.61.

It’s important to note, that the stock hasn’t consistently broken the EMA200 since its last short-term rally in February 2022, despite this recent encouraging movement. The stock could struggle to significantly extend its rally and I likely see some space for consolidation between the EMA50 and the EMA200, before a possible breakout or a retracement can be confirmed. For long-term investors, this price level is instead surely interesting as my rather conservative valuation model shows significant upside potential.

Author, using TradingView

AMD can count on significant institutional support among its shareholders with 66.92% of the outstanding shares owned by institutions, a relatively low short interest of only 2.17%, and less than one day to cover. The Street consensus given by 39 analysts prices the share on average at $123.33 with a buy rating, with the lowest estimation at $80 and the highest at $200. The Seeking Alpha Quant Rating is even more bullish and qualifies the stock as a strong buy, with A grades in terms of growth and profitability, A- grades for momentum and revisions, and a C for the valuation grade.

The bottom line

While an investor is less subject to the market timing problem, traders are more exposed to short-term volatility, depending on the time frame in which they deploy their strategy. AMD has a very encouraging long-term prospect, and in this perspective, I consider the price to be attractive. From a trading perspective, in my opinion, the stock now has some technical burden which could lead to some consolidation in the near term.

Fundamentally, the company is a rare pearl in terms of market opportunities and could strategically position itself on strong secular growth drivers. The recently approved US Chips and Science act which is meant to boost the competitiveness of domestic semiconductor manufacturers is in my opinion still not priced into AMD’s stock and could lead to further gains in its price.

Although the company is subject to heavy competitive pressure, AMD continues to be a technological leader with a potentially growing market share in the coming years. I consider the actual upside potential of 25.46%, pricing the stock at $123.06, as attractive and rank the stock as a buy, but I am aware of the higher market volatility and the downside risk and would in any case, as I always do, set an appropriate stop-loss, based on my contingency plan.

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