Valuation Still Is a Big Question Mark for AMD Stock

What Advanced Micro Devices (NASDAQ:AMD) has accomplished is truly impressive. It’s easy to forget amid the volatility in AMD stock over the past year, but even at the lows the turnaround here has been mind-boggling. Advanced Micro Devices stock traded below $2 as recently as February 2016. In a little over three years, it’s risen over 1,200 percent.

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The gains have been well-earned. Simply put, this isn’t the ‘same old’ Advanced Micro Devices. New efforts in GPUs and datacenter have made it a worthy rival. AMD isn’t just a lower-cost alternative to Intel (NASDAQ:INTC) for cheap PCs, as was the case a few years ago. Advanced Micro Devices now is a well-rounded innovativechipmaker.

It’s not as if investors haven’t noticed the enormous operational improvements here. With AMD touching a five-month high last week, valuation has to be considered a concern.

Chip stocks on the whole remain off 2018 highs; sharply so, in some cases. That decline has come in part because of a notable change in attitude toward the industry. That change, and a stretched valuation, suggest that, as well as the company has performed, AMD stock may have run a bit too far.

The Case for Advanced Micro Devices Stock

AMD has risen 43% already in 2019, even with a 5.5% decline amid a market sell-off this past Friday. And there are some reasons for the gains.

For one, fourth quarter earnings helped the bull case. The quarter itself wasn’t all that impressive but the 2019 outlook had one key piece of good news. Non-GAAP gross margin is guided to exceed 41 percent.

Hitting that guidance would continue a solid trend of improvement in that metric. Adjusted gross margin was 34% in 2017, and 39% last year. Given that adjusted operating margins remain below 10%, the gross margin expansion obviously helps the fundamental case here. Improvement in that metric alone should drive profit growth of 20%+ in 2019.

But the target is important for more than just fundamental and quantitative reasons. Indeed, analysts already had largely incorporated that guidance: consensus 2019 EPS estimates are at $0.64, against $0.62 before the report.

AMD has steadily improved gross margin as it’s rolled out its EPYC, Ryzen, and Vega lines, so the improvement in that metric is a clear sign that AMD is gaining pricing power as those new products hit the markets.

In other words, the gross margin expansion is the fundamental proof that this is a better company. AMD isn’t competing against Intel and Nvidia (NASDAQ:NVDA) in datacenter and GPUs by undercutting on price. Rather, it’s launched competitive products that are winning on their own merits.

That’s the bull case for AMD stock right there. And it’s amplified by the fact that AMD started from basically zero in datacenter, and something close in GPUs. Its addressable market is expanding, which means increased share can drive growth for years to come.

The Risks to AMD Stock

The question above $26 is whether those years of growth are priced in. AMD trades at 27x 2020 EPS estimates – which imply something close to 50% year-over-year growth.

That’s a big number for a semiconductor stock. The steep fall in NVDA shares shows that investors now might be less comfortable paying growth stock multiples for what clearly are still cyclical companies. It’s also being driven by customer caution in datacenter and signs of a ‘crypto bubble in GPUs. Both issues are likely to hit AMD profits in the first half of the year, with investors pricing in a rebound in the second half and into 2020.

Even with NVDA rallying of late, that stock actually is cheaper on a forward earnings basis. If the expected industry rebound does materialize, that company should benefit as much as AMD, if not more. This especially is true given larger market share in GPUs and more aggressive moves in datacenter.

And it’s not guaranteed that recovery is on the way. Last year, semiconductor equipment stocks like Lam Research (NASDAQ:LRCX) and Applied Materials (NASDAQ:AMAT) moved down before the share prices of their customers did the same.

They, too, have rallied but still sit at valuations that suggest the industry is closer to the end of the cycle than the beginning. The argument made last year that the industry as a whole was no longer cyclical in retrospect looks far too optimistic. So, too, do the valuations assigned chip stocks – including AMD.

Caution Required

Again, AMD has earned its gains of late. But it does seem like an awful lot of success remains priced in. The 2020 expectations require another step higher in gross margin against increasingly more difficult comparisons. Questions still surround the industry as a whole, as well as in datacenter and GPU demand,  two categories that have driven much of AMD’s recent growth.

To be sure, there have been skeptics for much of the last three years and most have proven to be short-sighted. But AMD’s growth over the next three years will be tougher than the performance of the last three. It’s made its big moves in GPUs and datacenter. It’s established itself as a legitimate competitor. From here, the road gets tougher.

The win with Alphabet (NASDAQ:GOOG,GOOGL) has driven optimism of late. But James Brumley made a strong case that AMD’s potential may not be what investors believe and I’m inclined to agree. Alphabet hasn’t proven to be all that effective outside of search and console makers and game developers are likely to resist the company’s cloud-based gaming offering.

This still looks like a case where going forward, AMD will have to grind out market share gains and gross margin expansion. It no doubt will have some success. The question, at 27x next year’s earnings, is how much success is needed to keep AMD stock moving higher.

As of this writing, Vince Martin has no positions in any securities mentioned.

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