Shares of Advanced Micro Devices Inc. (AMD, Financial) gained recently on news that Alphabet's (GOOGL, Financial) Google will use its 7 nanometer chips in its cloud computing servers. According to Jefferies analyst Mark Lapacis, the new agreement with Google is quite a coup for AMD, as the cloud server chip sector is a $25 billion a year market.
This is a big boost for the company and, undoubtedly, is responsible for generating renewed investor enthusiasm. After the March 21 announcement, the stock was up over 8% for the day. In the short span between Feb. 28 and April 5, AMD shares rose 23%; the stock is up an impressive 57% year to date.
The company also benefited after Google announced on March 21 that it would be using AMD’s graphics processing chips for its streaming video game service called Stadia. The stock shot up 12% that day on the news, adding a hefty $2.8 billion to its market cap.
What accounts for the stock’s dramatic climb?
A number of positive factors have recently coalesced, causing renewed interest by analysts impressed with the company’s product pipeline for 2019. Advanced Micro Devices achieved a significant milestone. Last year, the company introduced its 7 nanometer-based Rome server chips in the second half; smaller nanometer chips are more powerful. The rollout is a major turning point for the company as this product, for the first time ever, will place it ahead of rival Intel (INTC, Financial) for manufacturing faster, more power-efficient node processors.
AMD's stock has swung wildly over the past year, with a 52-week high of $34.14 and a low of $9.56. This volatility is, in part, due to analysts and investors changing sentiments regarding the direction and overall health of the semiconductor industry. The sector has many moving parts, including the burgeoning cloud server chip market, the timing and duration of cyclical downturns, which companies are better positioned to take advantage o, promising new markets and among these companies, which have the most impressive product pipeline. Some are overdependent on the smartphone market that has matured, lowering demand for chips. Samsung (XKRX:005930, Financial) is an example of a semiconductor company that is particularly sensitive to this downturn. Other companies, such as Nvidia (NVDA, Financial), are heavily reliant on gaming graphics chips that may experience slowing demand as gaming migrates to the cloud.
Given the meteoric and rapid rise of AMD’s stock over the last six months, have enterprising investors missed the boat? That depends, to some degree, on one’s prognostication for the semiconductor industry as a whole and the potential the gaming and cloud computing server markets might have on profit margins. In addition, due to its upward climb, the stock currently sports a whopping price-earnings ratio of 86.8, though this is down from its July high of 427.75.
It is also important to note that although the company is not exempt from the travails of the semiconductor industry, AMD is head to toes above its peers, while stocks like Nvidia have experienced sharp declines due to sudden drops in demand for their prime revenue-producing products. As indicated by the chart below, Advanced Micro Devices has enjoyed robust year-over-year earnings growth with a dramatic upswing since January. Since January 2017, AMD has an astounding year-over-year growth rate of 3,984%.
Return on capital is a good indication of how efficient a company is generating a return on capital invested. The measure has its limitations, as it is backward-looking and relies on the variable factor of current liabilities, but AMD has consistently maintained a range of 19% to 21%, a good indication of the ability of management to run the company efficiently by maximizing returns.
Operating margins of 6.97% are slightly better than the industry median of 6.76%; the company’s gross margin is 37.8%. Some analysts believe the gross margins will improve over the next year due to higher priced server chips. Bank of America Merrill Lynch chip analyst Vivek Arya believes gross profit margins will increase to 43.5% next year. On the downside, as noted by GuruFocus, AMD’s revenue per share has declined for the past five years. This may improve with the new contracts the company has in place for its server and gaming chips.
However impressive the recent stock gains have been, enterprising investors may want to assess the company’s current valuation against their view of the long-term potential of the gaming and cloud computing market, two sectors that could potentially boost AMD’s earnings growth. An important metric would be cloud computing companies' plans for capital spending.
Disclosure: I have no positions in any of the securities referenced in this article.
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