AMD: Business Performance Still Takes A Backseat

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As long as things are going well, investors tend to praise themselves for their outstanding stocking-picking or timing skills. When returns turn negative, however, it is almost always the market that has become “irrational” or some other external factor that was “impossible” to foresee.

The reason why I say this is that the sentiment around Advanced Micro Devices (NASDAQ:AMD) seems to follow this same pattern. Back in the summer of 2020, when I warned of the major risks associated with holding AMD, for most investors it was impossible to conceive a negative scenario for the company’s share price.

After all, how can you not be extremely bullish on future returns of one of the leaders of the booming semiconductors industry? As it turns out quite easy – simply ignore your emotional biases when investing as they almost always lead to poor returns.

Having said that, as AMD share price continued to rally over the course of 2021, both investors and Wall Street analysts grew ever more optimistic as the business continued to deliver.

AMD Price Target

Seeking Alpha

Although all that sounds logical, AMD’s exceptionally high returns over the course of 2020 and 2021 had little to do with the company’s strong competitive positioning. That is why, even as the share price jumped on the recently announced strong quarterly results, AMD still underperformed the broader equity market – both on an absolute and risk-adjusted basis.

Chart
Data by YCharts

Outside Factors Still In Control

As it turns out, the booming semiconductors industry has been among the heavy influenced sectors from the massive liquidity injection in recent years. This in turn, affected disproportionally high-growth names like AMD and Nvidia (NVDA).

That is also why AMD’s share price performance in recent years has been remarkably similar to that of Vanguard Growth ETF (VUG) versus the Vanguard Value ETF (VTV).

Chart
Data by YCharts

As a matter of fact, if we construct an index that takes daily returns of the VUG and from that subtracts the daily returns of the VTV, we will observe that AMD’s returns exhibit a very strong relationship with that index (see the graph below).

AMD momentum exposure

prepared by the author, using data from Seeking Alpha

What is more troubling is that AMD’s share price has become even more dependent on the dynamic of growth stocks versus value stocks in recent months. As a result, AMD’s share price is still at the mercy of the fading momentum trade and the tightening liquidity.

To put this into perspective, as I showed back in September, both AMD and Nvidia have been severely affected by the temporary influx of liquidity into the markets over the past few years. As such, they were also the worst hit as monetary conditions normalize.

AMD performance versus peers

prepared by the author, using data from Seeking Alpha

What that means is that in order for AMD to return to its previous highs of 2021, we would need a significant loosening of financial conditions to an extend of similar proportions to the one we saw in 2020-21 period.

But What About The Business?

As things unfolded, AMD continued to deliver on its strong data center and desktop roadmaps. Additionally, the cash flow rich business model of Xilinx has significantly expanded AMD’s total addressable market and provided an excellent addition to the company’s offerings in the data center space.

AMD Total Addressable Market

AMD Investor Presentation

AMD’s strong positioning in the already high-growth data center space has been the bedrock of the company’s margin improvement and topline growth in recent years.

AMD Data Center performance

AMD Q3 2022 Earnings Presentation

The segment also benefited heavily from the recent Xilinx and Pensando acquisitions, which were both highly complementary to AMD’s EPYC roadmap.

AMD and Xilinx business

AMD Investor Presentation

In recent quarters, however, we are being reminded that as lucrative as AMD’s business is, it remains highly cyclical in nature. The management is already very cautious on its Q4 expectations of the PCs and Gaming segments.

The guidance for Q4 really is around sort of PCs and, let’s call it, Gaming being lower, and again, those are — with all the holidays in place, we are not counting on too much there. And then Data Center is — Data Center, Embedded are higher (…)

Source: Q3 2022 Earnings Transcript

As trivial as this slowdown might appear, the Client and Gaming segments are the two largest for AMD in terms of revenue and both are experiencing a sharp drop in profitability. The former was loss making during the past three-month period as clients reduced inventory, while the latter noted a significant decline in margins as GPU pricing cooled-off.

AMD Client and Gaming segments

AMD Q3 2022 Earnings Presentation

This in combination with AMD’s high amortization charges following the Xilinx deal resulted in a quarterly GAAP loss for AMD, in spite of its other businesses firing on all cylinders.

AMD 2022 loss

AMD Q3 2022 Earnings Presentation

As tempting as it is to rely solely on Non-GAAP metrics, investors should be wary of such practices. Bitter experience even with high quality growth names shows that large and consistent disparity between GAAP and Non-GAAP margins could lead to disappointing returns.

In a nutshell, so far 2022 results for AMD are mixed even as growth persists and data center retains its lead.

AMD profitability by segment

prepared by the author, using data from SEC Filings

This leads us to the historical perspective of AMD where its Price-to-Sales multiple is usually strongly related to the achieved profitability. While, the current multiple of 3.8 is supported by AMD’s operating margin for the past 12-month period, there are a few takeaways from the graph below:

AMD margins versus valuation multiples

prepared by the author, using data from Seeking Alpha and SEC Filings

  • Firstly, investors should carefully monitor AMD’s GAAP margins not only in the data center space, but across the business as the business model is highly sensitive to changes in the business cycle.
  • Secondly, the valuations of the 2019-21 period were largely a one-off event and it remains highly unlikely that we will see such high multiples again.
  • Lastly, although AMD’s business model has evolved in recent years, investors should keep in mind the 2002 and 2007-08 periods as stark examples of what a prolonged recession could mean for AMD’s margins.

Investor Takeaway

Outside factors are still in control of AMD’s share price performance even as the business continues to deliver on its product roadmap. Although market exposure is an issue for all cyclical and high beta companies, in the case of AMD the company’s share price is far too sensitive to the fading momentum trade. This brings significant risks that most retail investors are failing to properly account for. At the same time, the early signs of softness in the Client and Gaming business units present yet another risk factor for AMD’s share price and will likely weigh on returns over the coming year. As a result of all that, AMD’s risk-reward ratio is far less attractive than what the exciting narrative built around the company portrays.

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