AMD’s Cost-Effective Strategy Is Intelligent, But The Valuation Is Troubling

The company’s long-term challenge will be driving profitability while remaining relevant

By Oliver Rodzianko

Summary

• AMD’s strategic focus on cost-effective, advanced compute aims at a distinct market segment, potentially underleveraged by Nvidia’s broad AI ecosystem focus.
• The stock’s valuation indicates the market expects it to achieve long-term profitability after its present top-line growth phase.
• Future market shifts and changes in demand could result in further investment required by AMD to expand its offerings, delaying profitability expectations and causing stock price volatility.

Advanced Micro Devices
AMD
Inc. (AMD, Financial) is one of the world’s favorite artificial intelligence investments currently. I believe its position in the market is very clever, as it focuses on appealing to cost-conscious buyers still looking for advanced computation capabilities. However, I think we should remember that Nvidia (NVDA, Financial) by far offers the most expansive ecosystem for AI, and it is developing this into something truly special. AMD can compete in the portion of the market it is targeting, but the long-term prospects for the stock remain speculative given the present valuation multiples.

Operations analysis

AMD is one of the most compelling companies working in AI chip development, but its most significant, and certainly stronger, competitor is Nvidia. For quite some time, I have been concerned about whether the valuation of the stock is too risky, and it is fair to say the investment comes with potential valuation drawbacks, even though the company’s future growth looks good. I do believe the market has slightly gotten ahead of itself here with too much enthusiasm, and a correction could occur. But it must be said that AMD is firing on all cylinders as it relates to becoming even more significant in AI and, as such, I can see why the market has placed such a premium on the shares. One has to question, though, whether this premium is market enthusiasm or wider speculation from non-professional investors who are not tuned in enough to the fundamentals and instead just want to invest in AI.

The company is not just a powerhouse in advanced chips, where its production of central processing units and graphics processing units are key to operating AI technologies. It also offers a range of products and services for high-level computers. It is becoming apparent that it may be able to offer some competitive advantage over Nvidia in certain areas. While Nvidia is focused long term on the full-stack market for AI, similar to Amazon’s
AMZN
(AMZN, Financial) AWS, but specializing in AI services, AMD is focused on selling elite capabilities of compute at good value for money. The company is focusing on performance per dollar and innovative technologies at accessible prices, but the market notices this is an exceptional strategy. Unfortunately, it perhaps leaves little room for outside investors to reap the benefits at this time without taking on excess valuation risk because of how widely spread it is being accepted that AMD’s strategy is onto something vital.

Peer analysis

My research has shown me that Nvidia’s current position in the market is undoubtedly the strongest. In second place behind it, I believe, is AMD. But also important are Intel (INTC, Financial) and ARM Holdings (ARM, Financial) in GPUs, ARM, Qualcomm
QCOM
(QCOM, Financial) and IBM
IBM
(IBM, Financial) in CPUs and servers and Broadcom
AVGO
(AVGO, Financial), Texas Instruments
TXN
(TXN, Financial), Samsung (SSNLF, Financial) and Apple
AAPL
(AAPL, Financial) in custom semiconductor solutions. It is quite clear that the clever and best companies involved in technology software and hardware want to flesh out their own AI divisions, but there still comes the point where some outsourcing is necessary for top-level results. Apple produces its own chips now, which is its role in custom solutions, but other computer manufacturers who do not have the same trillion-dollar-plus market cap are going to be looking to Nvidia, AMD, Intel and others to provide the chips to fuel the demand for ever-increasing power in laptops, desktops and intelligent devices.

As smaller hardware companies seek to join the ranks of companies who offer AI integrated with devices, I believe AMD has the strongest competitive positioning if it continues to hone in on cost-effective advanced CPUs and GPUs. By doing so, it caters to a critical part of the market that other providers would be less focused on as they serve the larger, full-stack needs of conglomerates, big data companies and those working with highly advanced technology like robotics.

However, suppose AMD fails to flesh out its AI ecosystem effectively. In that case, it might lose out in its current target market to Nvidia more than investors are currently pricing into the stock. What customers are going to want is ease of access to advanced AI tasks. Beyond pure compute provision, a unified platform to manage AI workloads that Nivida is aiming for with its full-stack approach may be much more compelling in the long run as AI tasks become more complex and demand for advanced capabilities scales. This should apply even to smaller companies that can afford it. While AMD has partnerships to help in this regard, its profitability will suffer if it does not provide the core foundation for the demanded capabilities.

On that note, I am particularly keen on AMD’s balance sheet, which shows an equity-to-asset ratio of 0.82. In comparison, Nvidia’s ratio is 0.65, while Broadcom’s is just 0.40. I believe AMD’s strength in its balance sheet will serve it well with any needs that may arise where it needs to invest more heavily in full-stack solutions. The company can notably take on more debt without too much damage to its financial agility or sense of security for shareholders.

Valuation

First, consider the following chart, which presents the main valuation multiples of what I consider to be some of the most competitive peers to AMD:

From the above table, it is quite clear that AMD sells at a very high multiples, but we can also see its multiples are not uncommon in its industry for the major players, other than its free cash flow ratio, which is the highest of all the five peers listed. I believe there is some truth to the statement that AMD is investing heavily in future growth, so it is taking a profitability hit in the near term in exchange for long-term gains. I do believe AMD will stabilize its profitability in due course, and then its price-earnings multiples will become much more tolerable. But as we can see, its revenue growth has shown to be very promising, which is indicated in the lower price-sales ratio against Nvidia, ARM Holdings and Broadcom.

In my opinion, the valuation for AMD is not intolerable, but it certainly exposes investors to a lot of risks if it struggles in achieving expectations or if it struggles to manifest long-term profitability at a scale that investors are currently anticipating. It has proven it can generate rapid and lasting revenue growth, and I am certain in time, it will translate this into a stronger bottom line, but there is also the consideration of growing expenditures to remain competitive, especially as it relates to my comments about it not having a full-stack ecosystem, which it may decide it needs to develop, albeit at a smaller scale to Nvidia, to remain relevant. Therefore, I can see some long-term risk here which could cause present enthusiasm to deflate, and I think investors who bought in at present prices run the risk of losing a significant amount of capital if adverse conditions arise.

Putting the AI market valuation risks into perspective

I view AMD very favorably, so I think the market has priced the shares high for a reason. Based on my research of the industry, I have come to believe the present AI enthusiasm is not a bubble like during the internet boom of the 1990s. Instead, the results of this technological shift look to be much more profound and lasting, but the potential for speculative behavior still remains. While in the 1990s, many companies went to zero, in this period, I believe the potential for speculation simply means more likelihood of volatility.

I do not think we will see as many failed companies, primarily due to the expensive barriers to entry, but also because the financial benefits of AI will cause fundamental growth like margin expansion and potential deflationary effects on the wider economy. That will make AI businesses worth much more than dot-com companies were over the long term. AMD has proven itself to be a stand-out player, and so the likelihood is short-to-medium-term volatility with long-term growth. Now just does not seem to be the most prudent time to allocate to the company as a value investor.

Key takeaway

I think AMD could have periods of turbulence, but as long as it continues to allocate its resources with an effective strategy aimed at value and does not find it needs to invest too heavily in expensive new technologies, which may disrupt its long-term profitability, I believe the long-term returns should be good. It is not quite right for my risk appetite, and I do not believe it works for investors heavily focused on stock valuations, but nonetheless, the company’s operations are undeniably strong.

Disclosures

I am/we currently own positions in the stocks mentioned, and have NO plans to sell some or all of the positions in the stocks mentioned over the next 72 hours.