Advanced Micro Devices (AMD, Financial) has been on a run since the start of 2016 and hasn’t looked back. The stock is up a staggering 445% during the trailing 12 months and is up 27.1% year to date.
The outrageous performance can partially be attributed to the fact that the market didn’t have confidence in the new design promises, and the stock continued to tank during 2014 and 2015. Being on parity with Intel (INTC, Financial) on process technology was always going to be the critical success factor for Advanced Micro Devices. Thanks to the 14 nm process and, of course, Jim Keller, Advanced Micro Devices managed to deliver on its Ryzen promise.
The stock price action was also supported by Advanced Micro Devices' market in custom SoCs, data centers and a willingness to compete on pricing. Aggressive pricing is one of the key tacts that will allow Advanced Micro Devices to gain market share going forward. Advanced Micro Devices seems to be on track to complete this historic turnaround.
Advanced Micro Devicesis being priced arbitrarily
However, the stock can’t be priced arbitrarily based on the premise that Advanced Micro Devices is a turnaround company or it will gain market share. Every idea needs to be quantified in order to relate it to a fair value for the stock. Is Advanced Micro Devices worth $14 because the company will gain market share? How much market share does it need to gain to justify a $14 price tag?
The point is, assuming an arbitrary value for a company can be lethal in stock markets, especially when the market is already trading on a high side. Let’s analyze several market-share scenarios for Advanced Micro Devices to get a little perspective on the company’s valuation.
P/S is misleading; margins aren’t comparable
Starting from sales, Advanced Micro Devices is priced on par with Intel based on current sales. Advanced Micro Devices' price-sales (P/S) ratio is slightly above 3 as compared to 2.79 for Intel. See the table below for relative valuation:
Focus Equity Estimates and IR pages
The table clearly shows that Advanced Micro Devices is priced on par with Intel even with revenue of $4.27 billion, but there is a catch. The stock is priced similar to Intel on a P/S basis as management isn’t a problem and fixed costs don’t affect the sales metric. Therefore, even at a lower scale, the adverse effects of fixed costs can’t be seen. Valuation based on sales doesn’t work for Advanced Micro Devices given a different pricing mix and a different variable cost in comparison to Intel.
Gross profit multiple reveals overvaluation
EPS is a complicated and error-prone approach amid different cost structures of both the companies coupled with the fact that market share has to be projected for Advanced Micro Devices in order to get to a price target, but using gross profit for valuation eliminates the forecasting of error-prone indirect costs while capturing the pricing mix and market share growth of the company, comparing price to gross profit might reveal a multiple for valuation. See the table that follows:
Focus Equity Estimates and IR pages
Advanced Micro Devices is expensive when analyzed with the gross profit metric. This is due to the fact that Intel’s gross margin is more than 60% as compared to Advanced Micro Devices' average of around 27% during the last three years. This also points toward the inefficacy of using P/S for Advanced Micro Devices' valuation. As we know, Advanced Micro Devices has to compete on costs in order to take market share from Intel. Hence, price-to-gross profit becomes a relevant ratio for valuation. If Intel’s margin falls, the stock will retract accordingly; same should apply to Advanced Micro Devices from a valuation standpoint.
Now, using the P/GP multiple, a sensitivity analysis based on assumption of market share gain is done for Advanced Micro Devices. See the table below:
Focus Equity estimates
10% market share gain isn’t enough
If Advanced Micro Devices manages to take 10% market share from Intel, gross profit analysis reveals that the stock should be priced around $10.4. Current market valuation is justified if Advanced Micro Devices manages to take 20% from Intel’s Client Computing Group. Given Ryzen’s performance, a gain in market share is certainly in the cards. However, taking 20% of Intel’s market share won’t be easy given Intel’s ability to use unethical marketing strategies.
Price war – Intel can go that way
Further, Intel can simply compete on price if the company sees its market share materially challenged. Therefore, 20% market share gain seems to be a long shot for Advanced Micro Devices. A price war between Intel and Advanced Micro Devices can put further pressure on the earnings multiple, which in turn will take a toll on the stock prices of both Advanced Micro Devices and Intel.
It’s just a matter of time. Once Intel rolls out 10nm parts, it will be the same old story for Advanced Micro Devices. High-end markets will belong to Intel.
Verdict
Advanced Micro Devices certainly has a point to prove in this window of opportunity when the companies are on the same node, but even Ryzen isn’t enough to justify a $14 price tag amid Intel’s bag of marketing, pricing strategies and node lead going forward; gross profit multiple confirms the thesis.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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