AMD: Growth Priced As Value (NASDAQ:AMD)

Investment thesis

The NASDAQ composite index has dropped more than 22% YTD. And such large market corrections have created many opportunities to buy high-growth stocks at an attractive valuation.

Advanced Micro Devices (NASDAQ:AMD) is a high-growth company that is now priced as a value investment. AMD prices have dropped 33% YTD. At the current valuation, all its negative scenarios have been fully priced in. Furthermore, AMD’s true economic or owners’ earnings have been consistently better than its accounting earnings. You will see that its valuation is even more attractive than on the surface, by about 30% based on a Greenwald analysis to adjust for the growth CAPEX.

Positive scenarios, on the other hand, have been downplayed or even ignored. Key near-term catalysts include the Xilinx synergies and further margin expansions. Xilinx not only provided immediate financial benefits (adding $559 million in revenue in the six weeks following the acquisition) but also enormous long-term opportunities to expand its addressable market. On a non-GAAP basis, its margin increased to a record 53%. AMD now boasts a solid product portfolio, which will almost certainly drive the margin further higher in the next quarters by switching its product mix to higher-margin offerings like EPYC, Radeon, and Ryzen.

AMD’s accounting EPS and owners’ earnings

The commonly quoted PE for AMD is based on the GAAP accounting earnings. And as of this writing, it varies in the range from 19x to 37x depending on whose report you read (e.g., Yahoo Finance or Seeking Alpha) and the basis of the EPS you use (annual, TTM, FW, et al). Besides the variance, such commonly quoted PE does not reflect its true economic earning power. And in AMD’s case, the accounting earnings underestimate its true earning power by a sizable margin.

You can already see the discrepancy by simply looking at the free cash flow (“FCF”) and EPS comparison shown in the following chart. The chart shows the accounting EPS per share and FCF per share for AMD over the past few quarters. You can see that its FCF has been consistently higher than EPS (i.e., and FCF-earnings conversion ratio consistently above 1).

In the next section, we will see that even the FCF already underestimates the true owners’ earnings because ALL CAPEX expenses have been considered a cost in the calculation of FCF.

AMD’s growth CAPEX and owners’ earnings

The key to understanding the OE is to distinguish between growth and maintenance CAPEX. Growth CAPEX is optional and should not be considered a cost. For decades, investors like Warren Buffett have promoted this concept. The following quote from Buffett best describes it (I added the emphasis):

These represent (“a”) reported earnings plus (“b”) depreciation, depletion, amortization, and certain other non-cash charges…less (“c”) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume…Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (“c”) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes…All of this points up the absurdity of the ‘cash flow’ numbers that are often set forth in Wall Street reports. These numbers routinely include (“a”) plus (“b”) – but do not subtract (“c”).

However, estimating (“c”) is indeed difficult and involves a more advanced understanding and analysis of the financial statements. The basic concepts and steps are detailed in my earlier article on AAPL. And in this article, I analyzed (“c”) for AMD using Bruce Greenwald’s method (detailed in my earlier article or Greenwald’s book entitled Value Investing).

Under this background, the following chart shows AMD’s true economic earnings compared to its accounting EPS and FCF in recent quarters. This analysis was carried out utilizing Bruce Greenwald’s approach. In determining the ratio of PPE (properties, plants, and equipment) to sales ratio, I used a five-year moving average. A few key observations from this chart,

• AMD’s OE is significantly higher than both its FCF and its EPS. As an example, it reported EPS of about $0.4 per share last quarter and FCF of about $0.65 per share. However, its OE is about $0.85 per share, about 30% higher than its FCF and more than 2x than its accounting EPS.
• The reason that its OE is substantially higher than both EPS and FCF is that most of AMD’s CAPEX are for growth, not maintenance. To me, this is a sign of a high-growth compounder. It shows AMD can employ large amounts of incremental capital to pursue new growth opportunities, to be elaborated more later.

Valuation is low and growth is even cheaper

The next chart compares AMD’s current valuation against its historical valuation and also the valuations of the overall market. At its current price, AMD’s valuation is about 19.2x PE based on its FW accounting EPS, already below its historical average and also the NASDAQ 100 index. The NASDAQ index is valued at about 33.8x PE when represented by the QQQ fund (based on Yahoo Finance data). So, in relative terms, AMD is almost ½ of the valuation of the NASDAQ 100 index (56% to be precise). In terms of the owners’ PE, its valuation is even lower based on the above discussion. It is only about 17.6x.

In terms of growth, the discount is even larger. As you can see from the following chart, the current PEG ratio for AMD is only about 0.31x. If we assume the overall stock market has an annual growth rate of 10% (a generous assumption), then the current PEG ratio for the NASDAQ 100 index would be about 3.38x, more than 10 times higher than AMD. AMD’s growth is too heavily discounted to ignore.

Further growth catalysts

There are further growth catalysts that the market has not priced in yet, creating more potential for AMD’s profit to grow and margins to expand.

The first catalyst involves Xilinx acquisition. The acquisition of Xilinx by AMD was completed on February 14, 2022. Xilinx provides AMD with many high-margin, long-term income streams across a new set of markets. The Xilinx acquisition not only produced immediate economic benefits (it added $559 million in revenue for the six weeks after the acquisition concluded), but also created enormous long-term opportunities for AMD to expand its addressable market such as Versal HBM adaptive SOCs, FPGA-as-a-Service, 5G, and also more futuristic AI technologies.

The second catalyst involves further margin expansion. As you can see from the following chart, its margin expanded to 50% in the last quarter of 2021 and then to a record 53% in the latest quarter on a non-GAAP basis. As aforementioned, if the profits are more properly interpreted to adjust for the growth CAPEX investments, its margin will be already considerably higher. AMD currently enjoys a strong product line, which is very likely to push the margin even high in the next few quarters. The Enterprise, Embedded, and Semi-Custom segment more than doubled its volumes in recent quarters. It has also been enjoying huge success, shifting its product mix to higher-margin offerings, like the EPYC, Radeon, and Ryzen lines.

Final thoughts and risks

AMD is currently a high-growth stock priced like a value stock. Its valuation is further distorted by its heavy investment in growth CAPEX. With a PEG ratio less than 1/10 of the overall market, it’s viewed almost as a permanently stagnating stock. All its negative scenarios have been fully priced in, and positive scenarios have been discounted or even discarded. Key near-term catalysts, the Xilinx synergies, and further margin expansions create very favorable and asymmetric return/risk profiles.

Finally, AMD investment involves both short-term and long-term risks. In the near term, AMD faces market demand renormalization risk. In the post-COVID market, PC demand is dropping and may dampen demand for AMD chips. Individuals adjust their working habits amid the COVID epidemic and raised PC demand. Now global PC demand is exhibiting symptoms of renormalization. Additionally, in the long term, AMD faces competition and pricing power risks. AMD constantly competes with other companies (such as Intel (INTC), NVIDIA (NVDA), QUALCOMM (QCOM), et al) in the chip space to build smaller, faster, and cheaper products. The competition can further extend to other areas such as manufacturing and its console business.