AMD: Premium Price For A Second Tier Chip Player (NASDAQ:AMD)

JHVEPhoto Introduction Advanced Micro Devices, Inc. (NASDAQ:AMD) is the world’s number two player in both the CPU and GPU, behind Intel Corporation (INTC) and NVIDIA Corporation (NVDA) respectively. The stock has been a high-flier over the past number of years on AI excitement. However, the market appears to be getting concerned about the lofty valuation amid signs the firm’s data center GPU offering may not be as hot as initially expected. The firm sits in an awkward position as the distant number two player in the GPU accelerator market. The stock had previously outperformed in hopes it would pick up market share as large cloud players sought to diversify away from Nvidia to reduce reliance on a single vendor. I, however, see AMD as significantly threatened, by the move by the cloud hyperscale players to develop their own custom chips in-house. Large cloud players such as Microsoft Corporation (MSFT), Alphabet Inc. (GOOG), (GOOGL), and Amazon.com, Inc. (AMZN) have all been making significant investments in custom silicon to reduce reliance on third-party vendors such as AMD. This coupled with the increasing presence of firms providing Application Specific Integrated Circuits or ASICs, such as Broadcom Inc. (AVGO) leaves AMD looking particularly vulnerable in my opinion. The bull case for AMD looks to be reflected in the current price, given the lofty valuation multiple. I see an apparent danger to that thesis. Hence, I am recommending a sell on AMD. Earnings AMD last reported earnings at the end of April, with numbers that did not impress the market. Shares fell close to 9% on the day despite a top and bottom-line beat. The devil was as always in the detail. The big disappointment was the guide for AI-specific revenue, primarily through the sale of data center GPUs, such as the flagship MI300. CEO Lisa Su guided that for the full year, the firm should achieve revenue of about $4B, an increase in guidance from the prior expectation of $3.5B. On the surface, this appears a reasonable result, but when we consider that analysts were thinking guidance might be closer to $5-6B, we see this was a massive miss to consensus. Even more disappointingly, Su confirmed the limited guidance upgrade was, in fact, a demand-related factor and not due to supply being capped. See below her response to a question on the subject from Vivek Arya of BofA. “Yes. Vivek, let me try to make sure that we answered this question clearly. From a full-year standpoint, our $4 billion number is not supply capped. (Lisa SU, CEO, Q1 Earnings Call). AMD’s results do not paint a pretty picture of demand, given the industry is experiencing a massive boom. We need only contrast results with Broadcom, which saw their shares jump 9% as they disclosed over $3B in AI revenue in the quarter alone. We also have reports Broadcom is working with OpenAI to develop custom AI chips, a clear indication they are not experiencing any demand headwinds. Then, when we layer in the big cloud players’ custom silicon initiatives, such as Google’s TPUs, Microsoft’s Maia accelerator, or Amazon’s Trainium chips I think alarm bells should be ringing for AMD’s prospects. Why are they only modestly raising product revenue guidance in the midst of an industry-wide demand boom, especially when we know it is not a supply issue? To me, it looks clear-cut that AMD has fundamentally weak demand compared to their competitors, which makes me think the current consensus is far too optimistic. Valuation The valuation for me is another negative aspect of AMD’s stock. The stock trades on close to a 40x forward P/E, despite generating a rather measly 1.7% ROIC and a net margin of just 4-5%. Koyfin What is perhaps more concerning to me is the often-overlooked gross margin profile of the business. Gross margin is a measure of profit a business makes solely from the direct cost associated with producing and selling its goods. It comes before we account for items such as R&D, marketing expenses, etc. AMD’s gross margin of around 50% sharply trails chip rivals such as Nvidia or Broadcom, both of which boast margins of around 75%. This indicates to me that at the product level, AMD’s rivals are vastly more profitable. I think this best illustrates to us that AMD’s peers are fundamentally better businesses and are likely to generate significantly higher profits for shareholders over the coming years. Nvidia trades on a similar P/E multiple to AMD, and Broadcom is a measure cheaper at around 29x. Hence, we are paying more for less profits with AMD. The lofty AMD valuation is based upon a high EPS growth expectation, which as I have discussed faces multiple threats. Seeking Alpha Risks The clear risk to my thesis is higher than expected adoption of AMD GPUs by both enterprise and cloud customers. It is absolutely a real possibility that AMD could launch a GPU which competes with Nvidia’s offering. There is still the question of the software layer, which is a clear Nvidia advantage at present, but if AMD were to make inroads, they could pick up meaningful market share. The firm has been wonderfully led by Lisa Su, who has transformed the fortunes of the firm since taking the CEO role in 2014. It could turn out that the firm continues to relentlessly innovate and push ahead technologically. I fear AMD is an excellent company hemmed in by larger players all trying to achieve the same end goal. I think, on balance, the risks here are clearly to the downside rather than the upside. Given Su’s record over the last ten years, I do have to acknowledge the possibility of an upside surprise, despite the super high bar currently baked into market consensus forecasts. If we look at AMD on a PEG valuation basis, the firm trades at a very attractive 0.8x. The market clearly thinks EPS growth will be extremely robust over the coming years. I think the PEG ratio is likely as low as it is due to the inbuilt level of doubt regarding the growth forecasts. My expectation, based upon the thesis of rising competition from ASICs and custom silicon, is that current EPS growth forecasts are overestimating AMD’s potential. Koyfin Conclusion In conclusion, I believe I have laid out a clear case of why AMD should be a sell in portfolios in favor of stronger, more profitable names. Markets have been enthusiastic about the prospects of the number two player in the GPU race, riding the coat-tails of Nvidia. I see the GPU market as dominated by a clear incumbent at the top in Nvidia, with second place up for grabs. AMD’s tepid product guidance on recent earnings for its new flagship MI300 chip suggests customers aren’t exactly knocking the door down trying to get hold of AMD chips. The firm faces stiff competition both in the form of ASICs from Broadcom and custom silicon solutions being developed by the large cloud players such as Google’s new generation of TPUs. Advanced Micro Devices, Inc. stock is a sell for me due to the mixture of an expensive valuation, substandard profitability compared with peers, recent demand undershooting market expectations, and a host of deep-pocketed challengers in the accelerator chip space.

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