AMD Stock: We Are Close To The Bottom

Ultimately, my aim is to help you get ahead of the market and make investment decisions that enable you to get ahead of the competition and outperform the market. For AMD (NASDAQ:AMD), I continue to reiterate the view that the company looks well positioned for the future and attractive at current valuations. The company is trading at mid-teens P/E multiples, pricing in recessionary and slowdown fears. To me, I think that we are close to the bottom as there has already been a full reset on expectations for the PC market, and some reset in the gaming and data center segment. I am of the opinion that the bottom should be in once it is clear that the data center segment either corrects or shows some potential slowdown. With that, we would have significant upside potential as the sell-side analysts would have revised their earnings forecasts downwards and de-risked the expectations going forward.

Investment thesis

I have previously written an article on AMD illustrating my reasoning behind why I think AMD looks attractive with what has been priced in. With AMD, the sentiment has really turned 360 degrees. The stock was trading in the valuation P/E range of 36x to 51x from 2019 to 2021 as AMD continued to show promise in gaining share as well as delivering faster growth than its peers. However, in the past 1 year, the stock is down around 60% and sentiment around AMD is at all-time lows. This started with the fears that demand was cooling, and these fears are starting to materialize as semiconductor companies across the value chain are showing weakness in their results. AMD was also not spared, especially in the PC end market, while its data center end market remains relatively resilient. In my view, AMD continues to be well positioned for share gains, particularly so in the data center segment, where its competitors are less well positioned in the near term.

Robust performance and outlook for Data Center and Embedded segments

Data Center segment continued to grow in 3Q22 with 45% year on year growth, bringing the revenues from the segment to $1.6 billion in the quarter. This was driven by strong EPYC server processor sales. Embedded revenues for 3Q22 came in at $1.3 billion, up 1,549% year on year, as a result of the inclusion of Xilinx product revenue. The strong Data Center segment was supported by the deployment of EPYC server CPUs as well as strength in the Cloud as end-market revenues doubled from the prior year.

The Data Center and Embedded segments now contribute to about 52% of AMD’s total sales. I think that AMD’s Data Center and Embedded segments will continue its momentum into 4Q22 despite challenging macroeconomic conditions as a result of AMD’s strong position in the relatively more resilient US hyperscale market.

One of the reasons why AMD is seeing a relatively resilient US hyperscale market lies in the strong power efficiency advantage that AMD has over its peers. The need for power efficiency is very high due to the fact that the hyperscale market is trying to reduce operating costs in an inflationary environment. As I have written in my articles on Microsoft (MSFT) and Amazon (AMZN), large data center operators are seeing higher energy costs erode their margins. As a result of this need for higher power efficiency, I expect that AMD will continue to grow their Server CPU revenues as a result of its superior power efficiency and continue to gain share even in 2023. In addition, I note that AMD is no longer supply constrained for the Data Center business as weaker macroeconomic conditions has had to lower demand for AMD’s key partner, TSMC’s (TSM) saw demand for its 7nm process moderating.

Client business likely to recover in 2023

Client revenues were down 40% year on year to about $1 billion in 3Q22, down from $1.7 billion in the prior year in 3Q21. As a result, Client revenue mix fell from 39% in 3Q21 to 18% in 3Q22. This was due to lower processor shipments due to a weak PC end market as well as significant inventory correction across the PC supply chain. For reference, inventory levels increased to $3.4 billion, up 27% sequentially while days of inventory increased to 110 days in 3Q22, up 30 days sequentially. With relatively elevated days of inventory levels, there is the risk for inventory write-downs. In the 3Q22 quarter, AMD had inventory, pricing and related charges of $160 million in its client and graphics businesses.

In 3Q22, AMD worked with its customers to reduce inventory downstream. In the next quarter, AMD is guiding a modestly down Client segment, as they include the weakness in the PC end market and the continued efforts to clearing inventory in the last quarter of the year.

The main priority for management right now is to clear the inventory situation and as a result, the Client segment has been shipping below end market consumption in 3Q22 and will also do so in 4Q22. This has likely led to a difference in outlook for AMD’s Client segment compared to Intel’s (INTC) recent 3Q22 results, which saw its equivalent of Client revenues increasing 6% sequentially. Although that sequential increase in Client revenues for Intel was likely as a result of a pull forward of orders by customers to buy ahead of the expected Intel price hikes in 4Q22, Intel also expects sequential weakness in 4Q22 as a result of this pull forward of demand in 3Q22, which puts Intel in a slightly different situation than AMD. As a result of its continued focus on reducing inventory levels in the channel, AMD shared that the PC channel sell-through was higher than the Client CPU sell-in and it continues to expect shipping below end consumption again in 4Q22. The main positive, in my view, is that the aggressive stance at reducing inventory in 3Q22 and 4Q22 will ensure that AMD shipments for Client CPU will fall by 31% in 2022, which is much more than what I expected. As a result, this positions AMD very well for 2023 as a result of this aggressive clearing of inventory in the next 2 quarters.

As a result, I think that for calendar year 2023, we will see that AMD will be entering the new year in a better place in terms of inventory levels as management continues to correct the inventory situation as soon as possible by reducing shipments in the fourth quarter of 2022. While the macro conditions remain uncertain for 2023, I think that we will see the PC business recover in 2023 with the inventory situation having been behind us and with the strong suite of products in the Client segment product portfolio that will continue to drive the segment in 2023.

Cutting back operating expenses

As I have seen with so many other companies that I have covered, AMD also intends to be more prudent with operating expenses. This means controlling where they will be spending operating expenses on and to be strategic in their spending, including the growth in headcount. As a result of weaker consumer facing segments like in Client and Gaming segments, this will be where AMD has some scope to cut back on operating expenses.

I expect that AMD will continue to execute its long-term strategy by prioritizing spending and investing in its long-term growth by continuing investments in Data Center, Embedded, and commercial markets while being more conservative with consumer facing markets in the near term.

Valuation

To value AMD, I use a DCF model and forecast AMD’s financials for the next 5 years, discounting back to derive a 2023 target price. My 1-year target price for AMD is $90.50, representing 46% upside from current levels. This target price implies a 20x 2023 P/E multiple, which I think shows the conservative nature of my financial forecasts embedded in the model as I try to de-risk the forecasted numbers.

While the PC market is volatile, I think that I continue to like the risk reward perspective for AMD as the Data Center and Embedded segments looks well positioned for future share gains and a strong product portfolio will enable the business to stage a strong comeback in 2023 as fundamentals of the business remain strong. As recession fears get priced into the stock, I think that the company should not be trading at 2023 P/E multiple of 15x. As a result, I think that both the relative value and intrinsic value methods of valuing AMD does imply an opportunity for investors at the current stock levels.

Risks

Market share risks

There remains to be potential challenges and risks to AMD’s market share gains as it competes with rather competent companies that may ramp up competitive pressures to gain market share themselves. Intel and Nvidia (NVDA) compete with AMD in the microprocessor and graphics markets respectively. As a result, there is a risk that market share gains may not materialize if competitors ramp up pressure on AMD.

Macroeconomic environment

With significant revenues being contributed by the PC end market, the market might see further deterioration as a result of macroeconomic conditions worsening. If this risk materializes, this could result in further downside revisions to its Client revenues as a result of the weakening PC end market.

Customer risks

AMD has almost 35% of revenues derived from Sony (SONY) and Microsoft (MSFT), which brings concentration risks as weakness from either customer could lead to downside revisions for AMD.

Conclusion

AMD has been sold off given recession fears, a weak PC market and potentially, a weakening of the Data Center and Embedded segments as well. However, at the current valuation levels, AMD looks really attractive as I have explained, based on a relative value and intrinsic value perspective. I continue to like AMD given that I think that the Data Center and Embedded segments are well positioned in the next year, 2023, as supply is no longer a constraint and from the new product launches coming up. For the Client segment, I see that the company will be better positioned in 2023 as management attempts to clear the inventory situation in the current 3Q22 quarter and the next 4Q22 quarter, setting AMD’s Client segment nicely for 2023. Lastly, there are opportunities for operating efficiency gains as management looks to be prudent in challenging operating conditions. My 1-year target price for AMD is $90.50, representing 46% upside from current levels.

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