Things have not been pretty on Wall Street lately. Investors are freaked out that inflation has finally arrived to the party, and those fears have prompted a bond sell-off. Treasury yields have gone up. The equity risk premium has been squeezed. And a roaring January 2018 for equities has turned into a dour February.
For chip maker Advanced Micro Devices, Inc. (NASDAQ:AMD), the transition has been quite extreme.
AMD stock roared more than 30% higher in January 2018, versus a 5.6% rally for the S&P 500. But, so far in February 2018, AMD stock is down 14%, versus a 2.5% drop for the S&P 500.
This is to be expected for a highly volatile stock with a big valuation, hazy growth prospects, lots of competition and scant profitability. Short term moves in AMD stock will be big relative to the market.
I think tech stocks will rebound, and I think AMD stock could rebound with the sector. But I don’t think any near-term rebound should be construed as a long-term breakout. This is a sideways stock with a price ceiling of $15.
Here’s why.
Near-Term Rebound, Long-Term Sluggishness
I do think stocks offer an attractive value proposition on this sell-off, especially high-growth tech stocks. Investors are freaked out that higher rates are adding pressure to currently elevated equity valuations, but I don’t believe the numbers support this argument.
The 10-Year Treasury Yield is at 2.85%. The forward earnings yield for the S&P 500 is 5.59%. That means there is still a 274-basis-point spread in yields in favor of equities. If you ascribe to the Fed Stock Valuation model, that means equities are still greatly undervalued relative to bonds.
Granted, the Fed Stock Valuation model missed the 2008 Recession, but that was a recession, not an equities bubble. Considering economic data is only strengthening and earnings growth is as good as it has been in sometime, it’s unlikely we are staring at a recession. Consequently, the biggest risk to stocks right now is a valuation bubble, but relative to bonds, stocks are far from reaching “bubble” level.
Overall, I think this is a natural and healthy pullback in stocks that presents a compelling buying opportunity. Stocks will rebound, AMD stock included.
But I don’t think a near-term rebound in AMD stock thanks to a general rebound in stocks means that AMD stock has solid long-term growth prospects.
AMD went parabolic in 2016, traveling from $2 to $11. But then it went sideways in 2017, bouncing between $10 and $15. The sideways action had nothing to do with a deteriorating growth narrative at the company. In fact, one could argue that, thanks to a strong data-center push, AMD’s growth narrative actually strengthened in 2017.
The sideways action also had nothing to do with weakness in the chip sector. Peers NVIDIA Corporation (NASDAQ:NVDA), Intel Corporation (NASDAQ:INTC) and Micron Technology, Inc. (NASDAQ:MU) all had banner years in 2017.
Instead, the sideways action has everything to do with valuation. AMD stock simply got ahead of itself when it quintupled in 12 months. And, now, long-term upside on AMD stock seems limited at best.
Let’s assume that aggressive analyst estimates calling for earnings to double this year and grow by 50% next year are accurate. That puts fiscal 2019 earnings at 53 cents per share. At that point, revenue growth will have come down meaningfully to a mid- to high-single-digit range. Gross margins will be largely maxed out, with maybe 100-200 basis points of expansion potential. Operating margins will benefit from sales growth driving expense leverage, so you are looking at a few extra hundred basis points of expansion there.
Put that all together, and AMD is no more than a 30% growth story in 2020 — and likely a 20% growth story from 2019 through the next 5 years.
At best, then, AMD earns 69 cents per share in 2020 (30% growth on $0.53). The S&P 500 is currently trading at a 30% premium to its growth rate. If we throw that same premium on AMD in 2019 with a 20% long-term earnings growth rate, that means that AMD stock should trade at 26 times forward earnings on 2020 expected earnings 69 cents. That gets you to an $18 price target by the end of 2019/start of 2020.
Discount that by 10% per year (two years) and you get to a present value of just under $15.
Bottom Line on AMD Stock
AMD stock could be due for a near-term bounce if stocks find a bottom and rally.
But longer-term, AMD stock is still a sideways stock capped by a $15 price tag.
As of this writing, Luke Lango was long NVDA, MU, and INTC.
