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As Tempting as It Is, AMD Stock Still Comes down to Valuation

Vince Martin

It’s interesting to contemplate how different Advanced Micro Devices (NASDAQ:AMD) stock might seem if AMD stock hadn’t made its big run starting in mid-August. The chart of Advanced Micro Devices stock shows a three-month round-trip from $19 to $34 and back. AMD now is down about 42% from its highs, which seems disappointing.

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But that run aside, 2018 was a phenomenal year for Advanced Micro Devices stock. Even with the year-end pullback,  AMD was the best performer in the S&P 500 in 2018, rising almost 80%.

Earnings for 2018 are likely to rise at least 150%, depending on how the Q4 report next week plays out. When you consider that AMD stock traded below $2 (below $2!) as recently as early 2016, the gains are even more impressive. And those gains are deserved.

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As I wrote back in 2017, this no longer is the “same old AMD.” A company that not that long ago was a second-rate, second-tier supplier to a stagnant PC market now is a real contender in multiple end markets.

It’s challenging the dominance of Nvidia (NASDAQ:NVDA) in GPUs. It’s going after Intel (NASDAQ:INTC) (as is Nvidia) in datacenter chips with its EPYC line. Even in the legacy CPU business, the Ryzen line has moved AMD from being a supplier to the cheapest PC makers to a company that can compete on performance as well.

The long-running question here, however, is valuation. AMD’s long-term targets still suggest just $0.75+ per share in earnings, implying a a ~26x multiple at the current price. That’s a big multiple in the chip space, particularly given the pullback in the sector of late.

AMD has a great story, admittedly. But with Q4 earnings looming next week, I’m still not convinced there’s much upside left even if the story plays out.

The Cyclical Problem for AMD Stock

As I’ve highlighted elsewhere, there’s been a notable shift in the chip space over the past few months – a span which directly coincides with the big pullback in AMD stock. Through the first half of 2018, investors began to believe that the traditionally cyclical semiconductor space wasn’t cyclical anymore.

As an analyst put it back in March regarding equipment manufacturer Lam Research (NASDAQ:LRCX), in a “post-Moore’s Law world”, that cyclicality would fade. Increasing demand for data centers, automotive chips, and IoT (Internet of Things) would end the historic boom/bust nature of the semiconductor business. And so investors could value chip stocks like other tech plays as companies positioned for steady, year-after-year growth.

That theory, simply put, has busted. It’s why AMD, and LRCX, and NVDA and INTC and Micron Technology (NASDAQ:MU) have pulled back. This time does not appear to be different. Innovation leads to demand. Competition and oversupply follow, and pricing plunges. The cycle starts over with the next innovation.

If that’s the case, and investors at the moment believe that it is, AMD stock may have a problem, even below $20. A 26x P/E multiple doesn’t sound that extreme, particularly for a company growing earnings 150%+ this year. But that growth is going to slow.

Gross margin is heading toward 40% and likely a ceiling. For all the hype about EPYC and the Radeon GPUs, AMD remains largely a PC play. And that’s a flat end market where pricing pressure is going to continue. Even AMD’s apparent head start over Intel in 7nm is likely to be a short-term win.

It’s simply dangerous to pay 26x earnings for a cyclical stock unless earnings are at a bottom, not a top. Given AMD’s recent performance, it’s tough to make that case.

What to Watch in AMD Earnings

That said, it’s too early to toss the bull case for AMD stock completely. And there is a path to upside here with potential catalysts on the way as soon as the Q4 report.

For one, AMD is likely to update those long-term targets soon, after demurring on the Q3 conference call in late October. “Long term” originally meant 2020; as we move into 2019, it’s likely AMD will reset those numbers. And if AMD CEO Lisa Su can detail an EPS target of $1+, there’s room for a nice run given how much investors (wisely) trust her leadership and her guidance.

Secondly, gross margin is key in the next couple of quarters. There’s only so much share AMD is going to be able to take from Intel and Nvidia, which is going to determine its revenue growth. It can’t cut costs while ramping its competitive game. AMD has to be able to keep pricing intact and expand gross margins in order to increase operating margins and thus earnings per share.

There’s a bit of a “chicken and the egg” argument there, however. Gross margins only are going to increase if the competitive environment can stay rational and if AMD truly can compete on performance.

So the argument essentially comes down to whether this time AMD really is a rival to Intel and Nvidia in particular. Given what essentially was zero share in datacenter, and a tiny fraction of the GPU market, Advanced Micro Devices has plenty of room for share gains.

But anything other than enormous gains still seem priced in unless the chip space isn’t quite as tough as investors believe at the moment. And so I’m on the sidelines with AMD at $20. But I’ll be watching Q4 earnings closely because if AMD can keep gross margin up and continue to show impressive market share gains, it’s possible investors were right in August, not in December.

As of this writing, Vince Martin has no positions in any securities mentioned.

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