Advanced Micro Devices: Expectations Running Hot Ahead Of Q1

seekingalpha04-26

Advanced Micro Devices is well-positioned competitively in the AI arms race, with strong potential to further widen its footprint in the space.Lisa Su has stewarded the company well historically, ...

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GMT+8&nbsp;&nbsp;&nbsp;<a href=https://seekingalpha.com/article/4686602-advanced-micro-devices-stock-expectations-running-hot-ahead-of-q1><strong>seekingalpha</strong></a>\n\n\n</h4>\n\n</header>\n<article>\n<div>\n<p>Advanced Micro Devices is well-positioned competitively in the AI arms race, with strong potential to further widen its footprint in the space.Lisa Su has stewarded the company well historically, ...</p>\n\n<a href=\"https://seekingalpha.com/article/4686602-advanced-micro-devices-stock-expectations-running-hot-ahead-of-q1\">Source 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caution are macro/geopolitical headwinds, downward earnings revisions for Q1, and the stock’s collapsing momentum – which could bring the opportunity needed for long-term investors.   JHVEPhoto Intro & Investment Thesis Advanced Micro Devices (NASDAQ:AMD) stock, along with its semiconductor peers, has outperformed the broader market over the past year on the back of rising demand for artificial intelligence (‘AI’) accelerators. The company is well-positioned competitively in the AI arms race, with potential to widen its footprint in the space. Lisa Su has perhaps been AMD’s most effective CEO, capturing an edge over long-time competitor Intel (INTC) and focusing its efforts on emerging technologies. As a result, AMD has strong appeal in graphics processing units (‘GPUs’) and other AI-centric product lines. The surging demand for such products is a rising tide that should continue to lift AMD’s boat as an alternative to leader Nvidia (NVDA). AMD’s overall growth and profitability has been dragged down by cyclically underperforming segments, but the back half of 2024 and beyond look promising. Despite its growth potential and competitive strength, the market’s expectations for AMD at its current price are far higher than what it can reasonably produce, in my view. Additional factors signaling caution are near-term macro and geopolitical sentiment, downward earnings revisions for Q1, and the stock’s collapsing momentum – which could bring just the opportunity needed for prudent long-term investors. Strategy & Market Positioning Starting with the hottest segment, AMD has held a steady 3rd place in Data Center market share of the top 3 firms: Author, data from quarterly results Nvidia is a clear leader in Data Center between the three, thanks to an early technological edge in AI accelerators, enabling the company to capture 80% of the market. GPUs, which use parallel processing and are effective in AI and high-performance computing (‘HPC’), continue to be front of mind for investors as they have made up the bulk of early Data Center investment. Since December 2023, all three firms have released their respective top-tier GPUs in competition with one another. I am by no means a processor expert but expect AMD and Intel to have difficulty unseating Nvidia from the top spot, which arguably boasts the best-in-class processor with the Blackwell. Nonetheless, AMD looks poised to overtake Intel for second. The Data Center market is rapidly evolving and is set to grow at annual growth rates from 20% all the way up to 30%+ by some estimates, leaving plenty of room for AMD. AMD’s newly released GPUs, the Instinct MI300 series, already has seen a strong ramp in customer demand, with management raising its revenue guidance for 2024 to $3.5+ billion. The newest GPUs are also being used by Meta (META), Microsoft (MSFT), Oracle (ORCL), and other partners across cloud computing and AI workloads. Another interesting dynamic to consider is the shift from training to inference over the next few years. Analysts at UBS estimated that 90% of current chip demand is from training AI models, the much more computationally demanding step in machine learning. This is where Nvidia has been the clear winner. But inferencing looks to be more competitive and is where much of the cost in deploying AI models occurs. Less computational power means customers will look for lower total cost of ownership (‘TCO’), which may mean less compute power and more energy efficiency – areas both AMD and Intel are looking to take share. Training usually requires the parallel processing offered by GPUs, but inferencing’s lower demands allow for CPUs as well, which plays a bit more to AMD and Intel. AMD’s MI300X has had success with both inference and training, with CFO Jean Hu stating in a recent tech conference: So when we look at our customers, we do see demand, not only inference side, but the training side. One thing if you can imagine is training happened much earlier, inference is just ramping. So when we introduce our product naturally when the market is ramping, the demand is strong. Nvidia and Intel have similar confidence though, with Nvidia reporting that 40% of its 2023 Data Center revenue was from inference and Intel seeing itself as a formidable, cost-effective competitor in inference: The economics of inferencing are, I’m not going to stand up $40,000 H100 environments that suck too much power and require new management and security models and new IT infrastructure, If I can run those models on standard [Intel Chips], it’s a no-brainer. Looking outside this trio of chipmakers, an additional competitive threat within inferencing is hyperscalers like Google (GOOGL), Amazon (AMZN), and others who have invested in development of in-house inferencing chips. Less reliance on chipmakers by some of their biggest customers could eat away at topline numbers. Along with this shift to inferencing and a greater weight placed on cost of ownership, is software. All three chip making firms have worked to develop software platforms in tandem with their AI accelerators. The platforms enable customers to control the levers of parallel processing done by GPUs through a unified approach. Having a solid software offering creates switching costs for customers and bolsters a firm’s competitive advantage. Nvidia leads in software as well, with its CUDA platform released in the mid-2000s. AMD and Intel didn’t join the club until nearly a decade later. AMD sees the software space as up for grabs thanks to its open-source nature. The company’s progress here should help lock in market share gains and capture recurring growth. While I expect Nvidia to remain leader for the foreseeable future, AMD has a history of strategic nimbleness, thanks in large part to CEO Lisa Su. Intel and AMD had long been in competition for the ubiquitous CPU x86 architecture created by Intel and replicated by AMD, which eventually led to a settlement allowing both firms to compete in the x86 market. Then in 2009, AMD went ‘fabless’ by breaking off its manufacturing arm to focus more on chip design. Su outlined the rationale stating: When you think about what do you need to do to be world class and design, it’s a certain set of skills,” Su said. “And then what do you need to do to be world class In manufacturing? It’s a different set of skills and the business model is different, the capital model is different. It then built a strong relationship with the top chip manufacturer in the world, Taiwan Semiconductor Manufacturing (TSM). AMD became a more capital-light, flexible, and innovative chip company while Intel continues to pour billions into manufacturing. Su also reoriented the company away from the cyclical Gaming and PC markets to tap into new areas of growth like Data Centers, custom design, and Embedded applications through the acquisition of Xilinx (leader in FPGA). This move toward higher growth, lower capex verticals became huge tailwinds for the company and helped widen its moat. The result was AMD passing Intel in market cap two years ago: YCharts Su’s leadership puts the company in a strong competitive position to continue taking share across each of its businesses. Performance & Outlook Despite being a fairly cyclical stock, AMD has grown revenues at 5- and 10-year averages of 28% and 16%. AMD’s topline growth has outpaced Intel but fallen short of Nvidia: Seeking Alpha The company’s growth was hampered in 2023 as its Client and Gaming segments are working through a lower demand environment, with sales decreasing 25% and 9% YoY. The bright spots were Embedded and Data Center which grew 17% and 7%. The inclusion of Xilinx helped lift the Embedded segment which is also going through cyclical trough while Data Center continues to take more share of AMD’s revenue. Author, data from quarterly results Nvidia had similar trends in Data Center and Gaming revenue, while Intel had decreasing revenue across all its segments, further highlighting AMD and Nvidia’s competitive strength over Intel. AMD has expanded its gross margins from the low 30s to near 50 the past decade as their revenue mix has shifted to more profitable verticals. This shift has yet to make a lasting impact down the impact statement as operating margins peaked in 2021 at 22% but have since fallen to near zero, primarily due to increased R&D spend and recent acquisition costs. While I welcome the investment in continued growth and innovation, AMD lacks the same magnitude of operating leverage displayed by Nvidia with operating margins in the 50s. Seeking Alpha Looking forward to Q1 and beyond, Data Center will continue to be the needle mover for AMD. We saw earlier the strong demand ramp and sales expectations for its newest GPU. The company’s Data Center revenue growth has been dampened by slow growth in servers. Management expects demand to pick up in 2024 as customers begin a server refresh cycle. Adoption of AMD’s software solution will be another potential tailwind for Data Center revenue. Overall, leadership has placed AMD’s 2027 total addressable market at $400B, largely driven by AI and HPC accelerators, showing big confidence in the Data Center segment. The Client, Gaming, and Embedded segments are expected to drag down growth once more in Q1, but management sees a recovery in growth for Client and Embedded as the PC market stabilizes, demand for AI PCs picks up, and Embedded sales bottom early in 2024. Trends toward a bigger portion of revenue coming from Data Center and Embedded may help AMD capture the operating leverage investors are looking for as they command the strongest margins: Author, data from quarterly results Risks & Uncertainties AMD’s biggest risks are competitive, in my view. Should the company fail to generate meaningful growth and take market share, it may underperform. Nvidia continues to command the Data Center market with little sign of a slowdown, and Intel has significant resources to take more share as inferencing becomes the major driver in the market. Additionally, continued development of in-house chips on the part of hyperscalers could hurt the company’s sales. Nonetheless, AMD is led by capable management and has demonstrated competitive durability. Other risks include geopolitical and macro. TSM is a major supplier of AMD and operates in the volatile region of Taiwan. On the macro side, inflation has picked back up slightly to start 2024, causing investors to pare back their expectations around interest rate cuts. Continued tight conditions until the economy cools could put a damper on AMD’s overall demand. If demand continues apace on the other hand, supply constraints and longer lead times for chips and data centers could slow sales. Valuation Using a reverse DCF model, we can evaluate the market’s implied expectations given the current stock price. At about $154 per share, AMD would need to achieve the following to justify its price:  Grow revenues at 22% annually for the next 10 years Maintain a 22% operating margin for the next 10 years Grow cash flows at a terminal rate of 3% beyond year 10  This also assumes the company’s reinvestment rate stays fairly close to its historical numbers (D&A at 115% of Capex, Capex at 2.5% of revenues, and change in net working capital at 1.5% of revenues), a weighted average cost of capital of 9.9%, and a tax rate of 25% for the next 10 years. Author These expectations seem out of reach for AMD in my view, given that both the revenue and operating margin hurdles are significantly above historical averages. Even with huge potential in the Data Center market, estimated growth rates in excess of 20%, AMD’s other segments would have match its growth which is very unlikely. Not only are the Gaming and Client sections cyclical, both segments are expected to grow in the single digits the next few years. While Lisa Su has proven her ability to generate new growth verticals, it would take a huge lift to get revenues to $165B by year 2033. Investing is a game of uncertainties, so using the DCF model, I weighted upside, downside, and consensus scenarios to arrive at an expected value for AMD shares. I assigned the downside case a 75% probability because of my expectation that AMD underperforms its current market-implied expectations, a 15% probability it meets the expectations, and a 10% probability it exceeds them. The result was an expected value of about $113 per share, meaning AMD is overvalued by 26%. Author I also tested various internal rate of returns (‘IRR’) by changing revenue growth and operating margins. This IRR assumes that I purchase the current enterprise value of AMD and sell it in 10 years at the estimated terminal value, and that outstanding shares stay the same and all cash is reinvested. As you can see below, AMD would need to sizably outperform its current expectations to generate even a 10% IRR. Author Is AMD a Buy Ahead of Q1 Earnings? Despite its strong competitive positioning and growth potential, AMD’s baked-in expectations are too high to make it a buy in my view. But if the company’s Q1 results disappoint investors, we could see shares approach a more favorable price range. AMD shares have recently dipped from highs in the low $200’s and overall Q1 earnings revisions as tracked by Seeking Alpha are largely negative.   Seeking Alpha  If prices continue to slide, it may be just the right opportunity for prudent long-term investors to buy shares of this high-quality company. 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