If you liked Advanced Micro Devices (NASDAQ:AMD) stock at $59 in February, you should love it at $44 in March.
After all, little, if anything, has changed — except the price tag on AMD stock. The long-term opportunity to take market share appears intact. Short-term impacts from the coronavirus appear limited, at least so far.
The decline doesn’t mean valuation concerns are gone for good. Shares still aren’t cheap. I voiced some concern at $53 in February, and even at a lower price the fundamentals need to be considered.
But AMD stock has defied those considerations for years now. And if the company can keep delivering, I expect it will do so again.
AMD shares have lost about a quarter of their value since Feb. 19, when the stock hit an all-time closing high just below $59. There’s really one reason why: the market has sold off.
After all, there hasn’t been any material news over that stretch (with one exception we’ll get to in a moment). Indeed, all’s been relatively quiet going back to fourth quarter earnings in late January. AMD stock did fall almost 6% after the Q4 release, but it recaptured those losses within eight sessions and continued its rally.
The only logical catalyst, then, is the market. And trading has been ugly. Since Feb. 19, the NASDAQ Composite has dropped almost 20%. The Philadelphia Semiconductor Index is off 22%. And both of those figures include huge bounces on Friday.
AMD simply got caught in a market downdraft. Yes, shares modestly underperformed both indices, but even modest outperformance would still have led to a rather sharp pullback.
…Except Some Good News
The one significant piece of news came on Mar. 5, when AMD held its Financial Analyst Day. In a different market, it’s not hard to imagine AMD stock soaring on the disclosures made at that event.
Most notably, AMD set out five-year financial targets that suggest impressive growth. Revenue is expected to rise at a roughly 20% of the compound annual growth rate. That does include existing guidance for 2020, which implies a top-line increase of 28% to 30%. Still, AMD is expecting sales to rise about 150%, from $6.73 billion in 2019 to $16 billion or more by 2024.
Margins should expand nicely as well — and this is a key point. The ‘old’ AMD long struggled with gross margins, as it was basically a second-tier CPU (central processing unit) competitor to Intel (NASDAQ:INTC). AMD’s only way to compete was on price — a strategy which unsurprisingly didn’t work.
Indeed, as I’ve noted before, AMD posted a dramatic loss in 2015, a key reason why the stock dipped below $2 in early 2016. Even on an adjusted basis, the company posted an operating loss of $253 million for the full year. That was more than 6% of revenue. Adjusted gross margins in 2015 were just 28%.
The improvement since has been spectacular. In 2019, adjusted gross margins were 43%, up a full 15 points. Operating margins cleared 12%.
But AMD doesn’t believe that it’s done with that improvement. The long-term model suggests gross margins over 50%, as new, more competitive products driving pricing power. Operating margins are expected to get into the “mid-20s” on a percentage basis. In other words, from a business perspective, the next five years should look much like the last four.
What the Targets Mean for AMD Stock
If AMD hits its targets, its stock still has substantial upside ahead. 24% operating margins in 2024, on $16 billion in revenue, would suggest operating profit near $4 billion.
Interest expense should be modest (it was below $100 million in 2019, and may drop further). It’s likely that AMD’s tax rate will rise: the company expects an adjusted rate of just 3% this year, thanks in large part to deferred tax assets created by past losses. Using the federal statutory rate of 21%, net income would come in right around $3 billion — over $2.50 per share.
A mid-20s price-to-earnings multiple, roughly in line with what Nvidia (NASDAQ:NVDA) receives at the moment, seems appropriate. AMD’s growth won’t end in 2025, after all. That in turn would suggest a share price in the range of $70, and roughly 10% annual appreciation for AMD stock. A lower tax rate and/or better performance all suggest upside to that target.
Is the Target Too Low?
Of course, that target might raise the hackles of both bulls and bears. Bulls used to AMD’s astounding returns — the stock is up 1,500% over the past five years — might see such upside as far too modest. This, after all, was the best-performing stock in the S&P 500 in both 2018 and 2019.
The opportunities in cloud, gaming, supercomputers, and other growing end markets don’t seem priced into that five-year target. Nor do market share gains driven by Epyc, Ryzen, and other newer lines.
But the fact that AMD has soared so far means that at least some of those opportunities are baked into its price. Bear in mind that even after the pullback, AMD still trades at a whopping 68x trailing twelve-month adjusted earnings.
And in the roaring market of the past few years, it’s been easy to forget that 10% annualized returns are impressive — and worth grabbing. That’s doubly true now, in a world where the 10-year Treasury bond yields less than 1%.
Again, it’s still possible AMD could outperform that $70 target price (which itself is a rough estimate, rather than a precise marker). The business could grow faster than expected. The out-year multiple could be higher than ~25x.
Still, whatever the exact target an investor chooses, the returns are going to slow: another 1,500% return would give AMD a market capitalization over $700 billion, more than three times the figure currently assigned Intel.
Will Bears Roar Again?
Bears might point to the $70 target as supporting some skepticism. After all, AMD’s five-year plan is just that: a plan. Companies miss long-term targets all the time, and seemingly more often than not.
The skeptical response to those targets would be that ~60% upside over five years in an bullish scenario itself is a sign of risk. It suggests that even after the pullback, AMD is largely pricing in positive outcomes.
Cut compound annual revenue growth to 15% and operating margins to 21%, and 2024 EPS is closer to $2. That’s still pretty solid performance for the underlying business — but unless AMD is getting a 30x multiple at the end of that stretch, the stock trades basically sideways for the next five years.
Ironically, there are many fewer bears than there used to be — or at least fewer bears betting against AMD stock. Short interest began to plunge late last year, and as a percentage of shares outstanding is at its lowest level since the financial crisis. But even those on the sidelines might argue, at the very least, that the easy money has been made in the stock.
For most of the past decade, however, that argument has failed in dozens of stocks. Whether it’s AMD or Shopify (NYSE:SHOP) or Amazon.com (NASDAQ:AMZN), a focus on valuation over growth potential has, at best, led an investor to miss out on enormous gains. If that investor shorted those stocks, she’s usually been run over.
It remains to be seen whether that’s changed, and whether this recent broad market rout will bring fundamental analysis back to the forefront. If it does, AMD still has a chance to rise — if it hits its targets. If the ‘old’ market returns, AMD probably heads back to $59 in a hurry. And so for growth investors picking through the wreckage of tech, AMD has one of the more attractive cases out there.
Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets. He has no positions in any securities mentioned.