Advanced Micro Devices: A Few Thoughts After Xilinx (NASDAQ:AMD)

After rumors surfaced already in recent weeks, the much anticipated tie-up between Advanced Micro Devices (AMD) and Xilinx (XLNX) is now a fact, or at least the announcement is. Given the somewhat higher price of the target than rumored and a small setback seen in the market, shares of AMD have seen a small drop, yet I would not read too much into that.

Nonetheless, expectations on AMD and the new combination remain very high, yet remain supported as long as AMD continues to report just rapid growth, certainly versus some (struggling) peers.

Deal Terms

The deal in which AMD will acquire Xilinx values the latter at $35 billion deal as the transaction will be an all-stock deal, making that relative valuation count in such a scenario. Given that AMD’s stock has comfortably outperformed that of Xilinx so far this year, this timing element looks favorably.

Investors in the target will receive 1.7234 shares of AMD for every Xilinx share they currently own, which boils down to $143 per share in terms of Xilinx’s stock based on the 10-day weighted average of AMD’s stock before rumors about a deal broke. Hence, investors in Xilinx will on a combined basis own 26% of the equity of the combination which is valued at $135 billion on a pro-forma basis.

The deal is driven to create a leading higher performance computing company, giving the combination more firepower against the likes of Intel (INTC) and Nvidia (NVDA), with the latter recently announcing a big deal for ARM (NASDAQ:ARMH) of course quite recently.

AMD touts the product portfolio and diverse growth markets, with the deal being immediate accretive to margins, earnings per share and cash flow generation. AMD will bolster it positing towards the data center, gaming, PC, communication, industrial, aerospace and automotive, among others, setting the company up for multi-year growth.

With no debt incurred as a result of the all-cash deal, the pro-forma implications are relatively easy to see by simply adding the performance of both businesses. On top of this, some synergies are seen. AMD pegs these at $300 million, to be achieved within 18 months after closing, notably on shared infrastructure and improved purchasing power. That being said, this will take a while as closing is only seen late in the calendar year 2021.

Modeling The Impact

The deal presentation reveals some key pro-forma numbers which reveal that the multiples at which Xilinx is valued in this deal look much more compelling compared to AMD. This comes in part because the latter has real growth engines, is very well led and many investors expect a (partial) defeat for Intel going forward.

AMD reports sales of $8.6 billion on a trailing basis as Xilinx will add $3.0 billion in revenues. Of the $11.6 billion combined revenue base, Xilinx contributes 26% of pro-forma sales, exactly the same as the share ownership in the combination.

That is where the equality ends as the margin profile of Xilinx is much better than that of AMD, with gross margins of 70% being 25 points higher than AMD as the $1.0 billion in operating income contribution makes up more than 40% of pro-forma non-GAAP operating income number of $2.4 billion. The combination will operate with net cash of $2.5 billion, as we can now make some calculations.

Alongside the deal, the company reported its quarterly results, as AMD has a diluted share count of 1.23 billion shares. With Xilinx given a 26% equity stake in the combination, I peg the combined share count at 1.66 billion, translating into a $135 billion equity valuation at $81 per share, although shares have now fallen to $77 in part amidst a small setback in the markets.

Of course, the valuations are highly distorted because of great momentum in the third quarter. AMD’s third-quarter revenues rose more than 50% on both a quarter-on-quarter and year-over-year basis to $2.8 billion. This suggests that AMD reports revenues at $11.2 billion a year, as the company reported net earnings of $390 million for the quarter on a GAAP basis, or $1.56 billion a year.

Xilinx reported its second-quarter results last week with revenues down 8% on an annual basis to just over $3.0 billion run rate, for a combined run rate of $14.2 billion, suggesting it only contributes 21% to the current run rate in sales. Net earnings came in at $194 million for the quarter, or about $780 million a year. Combined, this comes in at $2.34 billion a year, as synergies could boost this number to $2.6 billion.

Given the diluted share count, this provides a boost to the earnings run rate of AMD, yet it only comes in around $1.50 per share per year, about equal to about the net cash holding of the firm. Thus, with operating assets now trading around $75 per share, this translates into a 50 times earnings multiple, and the enterprise value comes in around 9 times annualised sales.

A Final Thought

The deal with Xilinx makes sense as it will provide AMD with much more R&D and cash flow power, and while the deal is accretive to margins, it is dilutive to the growth rates. That said, the deal is really driven by adding great R&D capabilities to reinforce the growth and potential of the combination going forward.

As the valuation multiples are very steep at 50 times earnings, I do not see a compelling reason to get in onboard, yet one has to appreciate that AMD has been driving great operating performance thanks to its leadership and focus on R&D. After all, the company is delivering on >50% revenue growth which stands in sharp contrast to the small revenue declines reported by Intel, which is still 6 times as large in terms of the revenue base and is superior to many other peers as well.

Real innovation and R&D is what counts in such a market as besides superior growth, it is AMD which on top of growth still has more room on the margin front as well. Intel does report GAAP operating profits in a range of 30-35% which is still far higher than the 15-20% margins reported by AMD at this moment.

If the company can close the margin gap and report operating margins of 30% on pro-forma sales of around $14 billion, the picture looks already a bit different. With operating profits of $4.2 billion, no net interest expenses due and assuming 10% tax, that allows for earnings to increase 50% on the same revenue base to about $2.25 per share. This still results in very demanding valuation multiples, although growth reported by AMD provides a lot of comfort.

You get the point, investing in quality and winners is probably a long-term winning strategy in an industry which is not commoditized and capabilities really matter. AMD has been a great recovery story yet it feels very late in the innings, with the great dealership and transition now publicly getting acknowledged, making me a bit fearful that the best days are behind us already, that is for the shareholders at least.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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