AMD – A 77% Upside Is Possible But Only Through 2x Operating Margin In 2023

Mar 14, 2020
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Given the fact that Advanced Micro Devices, Inc (NASDAQ:AMD) is rightly an underdog in the industry, speculation about the company's future carries with it the potential to become controversial. Valuing the company based on assumptions about the future is tricky simply due to the fact that AMD is up against companies much bigger than it is - in terms of manpower, total assets, operational facilities, market share and other metrics.

Readers are reminded to recall that just a handful of years back, AMD wasn't generating confidence among investors, analysts and others. The company continually generated negative free cash flows in a worrying sign for a non-startup manufacturing concern, and the dire state of affairs at the time was admitted by AMD's chief financial officer Mr. Devinder Kumar at this year's financial analyst day when he commented on his company being able to achieve targets that it set for itself two years back.

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In fact, AMD was earning a negative net income in as recently as its fiscal year 2017 due to heavy spending in research and development. For the fiscal years 2015, 2016 and 2017, AMD's R&D expenses as a percentage of its total revenue stood at 24%, 23% and 23% respectively. For comparison, AMD's peer group had the following figures for R&D/Revenue:

R&D/Revenue% Intel IBM NVIDIA ON TI
2017/2018: 21% 7% 18% 11% 10%
2016/2017: 21% 7% 21% 11% 10%
2015/2016: 22% 6.5% 27% 11% 10%

AMD Needs To Balance R&D With Other Expenses If It's To Achieve A 77% Upside

Looking at these figures, it's clear that during the years AMD was struggling to post positive bottom-line results, it was outspending its peer group in terms of R&D%. The gamble paid off and as we all know, AMD took off in the stock market and started to post healthy bottom-line results consistently.

What this brief look at the past also tells us is that, as it should be expected, AMD's strong growth during the last two years has come through serious research and development spending. As of the fiscal year 2019, Texas Instruments' continues to spend 11% in research, Intel has brought it down to 19% through strong revenue growth, NVIDIA is once again up to 27% and AMD is trailing along at 23%.

Therefore, it's evident that AMD's investments into the future often end up cannibalizing current profitability -  a factor that we will allude to later on in today's analysis. All of the figures being used today have been provided by AMD's management at the financial analyst day, and our assumptions and those provided to us by @chiakokhua have been explicitly marked to separate them from the company's assumptions.

$ millions except EPS, P/E & fair value - all assumptions courtesy of @chiakokhua except a 25% operating margin based on the midpoint of AMD's long term financial model assumptions, a cash tax rate of 3%, 29% revenue growth this year and 20% growth following 2020 which were revealed by AMD at its financial analyst day. The price to earnings multiple of 25.83 is based on the Philadelphia Stock Exchange capitalization-weighted index of semiconductor stocks (PHLX Semiconductor Sector - iSOXX)'s weighted-average-price-to-earnings ratio and the 76.51% upside is based on AMD's closing price of $43.9/share on Friday.

By doubling its operating margin, chipmaker stands to grow revenue aggressively

The analysis shown above uses AMD's assumptions of 29% revenue growth by the end of this year and an average revenue growth of 20% starting in 2021. It further uses AMD's provided guidance for the operating margin and cash tax rate, and it incorporates the widely held belief that once it retires all of its debt, AMD will not take on more debt to fund either its operations, research or other expenses. Finally, the assumption of 1.2 billion shares outstanding at the end of the fiscal year 2023 is provided by @chiakokhua (Retired Engineer), incorporating the effect of future share buybacks on the company's fair value.

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These optimistic assumptions show that by the end of 2023, Advanced Micro Devices, Inc stands to have a share price of $77.49, in roughly 77% upside over Friday's closing price of $43.9. AMD's operating margin at the end of the fiscal year 2019 stood at 12.5% (operating income used: $840 million*), and the company needs to effectively double this if it has any chance at justifying a 77% upside. However, as we'll explain below, this is not the only overtly optimistic metric present in today's piece.

At the analyst day, AMD stated that it expects operating expenses over the long term to stand at 26% of revenue. Using this estimate and backsolving it in line with today's revenue lets us derive its corresponding value for an operating margin of 24%. Keep in mind that AMD's long term gross margin estimate is 50%, and what this means is that if the company's operating expenses stand at, let's say 24% instead of the stated 26%, then its operating margin will be 26% (Why? Because operating income = gross profit (not revenue!) - operating expenses).

Need for balance illustrated by 40% anticipated drop in marketing, general and other expenses

Using the 26% estimate lets us derive AMD's operating expenses for 2023. These stand at $3.9 billion for the year, and when we plug in the company's R&D/Revenue % of 23% at the end of the fiscal year 2019, we find out that if AMD is to justify these metrics, then its marketing, general and other expenses will have to drop by 40% in 2023.

This drop is assumed to take place at a time when the company has grown its revenues significantly, and should it achieve this, then history will bear witness to the competency of AMD's management.

All in all, AMD (NASDAQ:AMD) has set impressive financial targets for itself by the end of 2023, and if historical performance was an indicator of future results, then the company's future is set in stone.

*Computing and graphics operating income plus enterprise, embedded and semi-custom operating income as per 10K filing.

As always, readers are reminded to conduct their own due dilligence prior to making investment decisions. Wccftech, its staff, its writers, and its management do not hold any liability for the consequences of your trading decisions as a result of reading this piece. The writer does not have a stake in NASDAQ:AMD and does not intend to acquire one in the next 72 hours or in the near future.

The sole intention of this piece is to educate readers and consider the impact of varying variables on a company's financial statements.

Any accusations of impropriety made against Wccftech, its employees, and its management will be taken as slander with intent to harm.

 

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