Exclusive: A Critical Analysis of AMD’s Multi-Year Amendment to The Wafer Supply Agreement 2016
Advanced Micro Devices (NASDAQ:AMD) recently announced that it has amended the Wafer Supply Agreement with GlobalFoundries. The multi year amendment to the famous WSA will last for for the period of January 1st to December 31st 2020. The Wafer Supply Agreement is the contract that governs the strategic alliance of AMD and GlobalFoundries and has been present since the spin off in 2009. The involved parties in the contract are GlobalFoundries, AMD and Mubadala Development Company - which owns 100% of Global Foundries and currently owns 17.84% of AMD.
The terms of the multi-year amendment to the Wafer Supply Agreement
Before we enter into the nitty gritty of things, lets go over the highlights of the amendment. In addition to modifying certain terms of the WSA applicable to AMD's microprocessor, graphics processor, and semi-custom products, the amendment:
- Covers a 5-year period, spanning from calendar year 2016 through 2020;
- Establishes a comprehensive framework for technology collaboration between AMD and GF for the 7nm technology node, building on the success of the 14nm node;
- Provides AMD with the flexibility to manufacture certain products with another wafer foundry;
- Sets annual wafer purchase targets from 2016 through the end of 2020, fixed wafer prices for 2016, and a framework for yearly wafer pricing.
In partial consideration for these rights, AMD (NASDAQ:AMD) will:
- Make a $100 million cash payment to GF, paid in installments beginning in Q4 2016 through Q3 2017.
- Make quarterly payments to GF beginning in 2017 based on the volume of certain wafers purchased from another wafer foundry.
- Grant to West Coast Hitech L.P., a wholly-owned subsidiary of the Mubadala Development Company PJSC, a warrant to purchase 75 million shares of AMD common stock at a strike price of $5.98 per share. The warrant may be exercised in whole or in part prior to February 29, 2020. The warrant is only exercisable to the extent that Mubadala or its subsidiaries do not beneficially own, either directly or indirectly, an aggregate of more than 19.99 percent of AMD's outstanding capital stock after the exercise.
AMD expects to record a one-time accounting charge in the third quarter of 2016 of approximately $335 million comprised of the $100 million payment and the $235 million value of the warrant.
Analyzing the 6th Amendment to the Wafer Supply Agreement between AMD and GloFo
The amendment is of a very material nature to the outlook of AMD but before we get into that it is interesting to point out that this is one of the more significant amendments to the WSA that has happened so far. It comes almost a year after the amendment of 2015 and will officially be filed as the "The Sixth Amendment to the Wafer Supply Agreement". A copy of the filing is not currently available but AMD has promised to attach one with its next quarterly results.
The initial point of the contract was to make sure that AMD continued to buy a set quantity of wafers from the foundry every year and not simply shift to other foundries after the spin off. With almost every amendment AMD has attempted to re-adjust the grip of the WSA and paid corresponding monetary compensation according to the terms for doing so. Unlike the previous amendments however, this particular contract changes quite a few things for the duration it will stay active. The original Wafer Supply Agreement stated that it will stay active no longer than the year 2024, and this particular amendment will end on 2020. One thing is for certain though, it would seem that AMD is not as confident in the capabilities of GlobalFoundries as it once might have been.
The first and foremost change that you will notice in the amendment is that it offers Advanced Micro Devices (NASDAQ:AMD) "flexibility" in terms of the wafers it is required to buy.
- The quota set for this year is wafers worth $650 Million from GlobalFoundries by the end of 2016. (Out of which $155 Million have been delivered in Q1 2016).
- Unlike before however, the take-or-pay obligation is gone, but in its entirety.
- AMD is still required to pay for the amount it misses from the annual requirement, but only a portion of it and not the complete amount. How big this portion will be is not known at this point.
Of course, then you have the two one-time charges that AMD will be recording in connection to this deal:
- The $100 Million cash payment to GlobalFoundries to be paid in quarters.
- The $235 Million accounting charge for the warrant issued to Mubadala owned company.
The amendment also has interesting implications. Zen is critical to AMD's success and quite possibly its ability to stay afloat going forward. It can be argued that the company remaining a going concern depends on Zen not being a failure. With that context in mind, it is easy to see why AMD might be looking to diversify its options in case GlobalFoundries does not perform. While that does hint at the fact that the company might not be happy with the foundry at the moment, it is not something we can say for sure. It goes without saying though that with this amendment in place AMD is now free to look to either TSMC or Samsung to source a portion of its future portfolio of GPUs and CPUs. It is worth noting at this stage that Nvidia has also chosen to pursue a similar strategy and reached out to Samsung to diversify its foundry capabilities along with TSMC.
Since GlobalFoundries and Samsung share the same 14nm process, it is more probable that the amendment will be utilized to harness TSMC's ability to create high powered SOCs at the 16nm FinFET node. This amendment will also serve as a fail safe option for AMD's Zen processors - which are due to land sometime in early 2017. This is also the same year, that the penalty clause for Global Foundries comes into place. To put the entire structure of the amendment into perspective AMD will be paying the following payments on the purchase of a single hypothetical wafer not fabbed at GloFo:
- The normal cost of the wafer paid to the foundry its produced at, be it TSMC or Samsung.
- A penalty paid to GlobalFoundries for this wafer that is not produced at their foundry. This will be included to the total WSA requirement for the year.
- If AMD does not fulfill the target requirements of the WSA for the year, then AMD must also pay a portion (not the entirety) of the difference.
If you combine the above costs which are dependent on the volume of wafers with the one time charges ($335 Million Value) already incurred in the para before, we start to see that AMD is paying quite a heavy price for the “flexibility” to lean away from GlobalFoundries. This might at first glance appear to imply a somewhat bearish outlook to the company but the fact that the warrant Mubadala has bought has intrinsic value right now and will be more profitable if AMD (NASDAQ:AMD) performs even further, and considering these are companies which are probably well versed with AMD fundamentals and its future road maps, it helps negate some of that impression. Even though this is the first time penalties have been structured this way (the company has previously produced chips at TSMC without a double jeopardy penalty) the fact remains that at the end of the day, AMD now has the ability to choose from all three major pure play foundries for its 16nm/14nm and 7nm chip designs which reduces much of the foundry associated risk with its future Zen offerings as well as high end GPUs.
Analyzing the warrant issued to the Mubadala owned company
Here is the thing though, it is apparent that the warrant - which is basically an option for 75 Million shares of AMD Common Stock - has been issued to the Mubadala owned company as an additional compensation for amending the WSA. Before we get into the details surrounding the warrant its worth noting that even though AMD will be taking an accounting charge, this move shows that Mubadala is confident in the outlook of AMD since the warrant not only has intrinsic value but if AMD's stock price continues to do well it will be even more prfitable. This is why, the warrant can also be construed as a vote of confidence from Mubadala which already owns a significant share of AMD.
The first restriction regarding the warrant is that Mubadala and its subsidiaries cannot own more than 19.99% of AMD. Since West Coast Hitech L.P is a wholly owned subsidiary of Mubadala Development Company - this means that:
- With this warrant, the effective ownership of Mubadala will extend by 2.15% when exercised, considering their current ownership of AMD's common stock stands at 17.84%.
There is also an added caveat associated with this warrant: this is not simply an In The Money (ITM) American option given to them that can be exercised immediately. Consider the fact that AMD's Shares Outstanding are roughly 795.5 Million (795,557,811 Shares to be precise) and with ownership at 17.84% Mubadala and its subsidiaries own roughly 141.9 Million shares.
- If it is to stay within the 19.99% limit set by AMD, with its current ownership the company can only buy roughly 17.1 Million shares before it hits the limit.
- If Mubadala is to fully exercise the warrant worth 75 Million shares, then first it must dilute its holding by 40.8% and sell off roughly 57.89 Million shares of the 141.9 Million it currently owns. Only then it can exercise the warrant and buy 75 Million shares while staying at the 19.99% limit which maxes out at approximately 159 Million shares.
- Of course, this move cannot be performed in one go, since not only they not be allowed to dump that much on the market but will actually be counter productive for Mubadala (the massive increase in supply will result in the stock price adjusting downwards.), and will probably be performed over the course of the warrant in small calculated increments.
- All the numbers given above assume that the warrant is not dilutive in nature. If the warrant is dilutive however, then new shares will be floated and the total Shares Outstanding will increase to approximately 870.5 Million shares (870,557,811 to be precise). This means that the dynamics of the warrant change to the following. The new limit of shares that Mubadala can own becomes approximately 174 Million. Contracts like these are usually executed in their entirety, if that is not the case however, then Mubadala will be able to buy roughly 32 Million shares over its current standing before it hits the limit. Otherwise, it will have to dilute its ownership by approximately 30.2% and sell roughly 42.9 Million shares before exercising the warrant in its entirety.
With that in mind we can continue towards another interesting fact present in the press release by AMD. The company has taken an accounting charge of $235 Million for a warrant of 75 Million shares. This information coupled with the strike price of the warrant - which stands at $5.98 - allows us to reverse engineer the TWAP (Time Weighted Average Price) that AMD has used to compute the charges.
- Since we are looking at an average charge of $3.13 per share (235M/75M) on a strike price of $5.98 this means that AMD has used a TWAP (Time Weighted Average Price) of $9.11 from which the discount is calculated. This is also probably the reason why Jefferies has upgraded its price target of AMD from $6.75 to $9 today.
As to how AMD arrived at this average price is probably a venture into the speculative. But since a warrant closely resembles an American call option, the Binomial Option Pricing Model is something that can be used to arrive at a close enough approximation of the method AMD has used. In fact we were able to reach a close enough figure by using the implied volatility numbers given for AMD (65%), the current stock price $7 at the time of writing the option, the federal funds rate (0.5%) and the full time limit of the warrant. Of course, the standard binomial model tends to get less accurate the further out the expiry is so it only serves as a reasonable approximation to the model actually used to calculate the TWAP.
Also keep in mind that Warrants are usually dilutive in nature. This means that at the time of execution, and after the additional shares are floated, the stock price of the stock is adjusted automatically so the total Market Capitalization remains roughly unchanged. Of course, since we are dealing with an OTC derivative, the exact nature is hard to guess at. That said, if the warrant is not dilutive in nature, then AMD needs to buy back the shares at market price and create a reserve - which they will then sell to Mubadala. If that is the case then it will of course result in a very risky position on their books unless they have already accumulated their reserve. Our figures for the AMD Free Float show that this is probably not the case, but naturally, its possible that they haven't been updated yet and don't reflect the situation accurately.
Original Wafer Supply Agreement (2009) SEC Filing
Wafer Supply Agreement Amendment No. 1 (2011) SEC Filing | Summary
Wafer Supply Agreement Amendment No. 2 (2012) SEC Filing | Summary
Wafer Supply Agreement Amendment No. 3 (2012) SEC Filing | Summary
Wafer Supply Agreement Amendment No. 4 (2014) SEC Filing | Summary
Wafer Supply Agreement Amendment No. 5 (2015) SEC Filing | Summary
Wafer Supply Agreement Amendment No. 6 (2016) SEC Filing | Summary
Warrant of 75 Million Shares for West Coast Hitech L.P. 8-K (2016)