Chip giant Advanced Micro Devices (AMD) rallied more than 11% to close at $23.71 on Monday, but I see multiple reasons why it's overvalued here. Let's check it out.
Now, it's true that Advanced Micro Devices has a strong fan base, and its shareholders likely include gamers who use AMD-based products. Many probably see this as anecdotal evidence that AMD is an undervalued investment -- but it's anything but undervalued in my book. Here are five reasons why I say that:
1) A Shaky Share-Price Spike
AMD has rallied from around $16 in late July to nearly $24 now -- an almost 50% gain. However, keep in mind that earlier this year, AMD adopted a new accounting standard known as ASC 606, which relates to how companies recognize revenue from contracts with customers.
Essentially, this new standard spells out how companies should book recurring revenue. In practical terms, this means that whereas AMD used to historically report particularly strong third-quarter revenues, its sales were more proportionally recognized during each quarter of 2018.
Whereas AMD's second quarter was historically weak under the old accounting system, this year's second quarter benefited from ASC 606 pulling forward some revenue that the company would have otherwise recognized three months later. As a result, AMD's third-quarter revenues came in at a subdued 4% year-over-year gain, but its second-quarter revenues shot up a massive 53% vs. the year-earlier period.
Now, AMD had been heavily shorted earlier this year, often making the list of the Nasdaq's top five most-shorted stocks. Thus, when AMD reported the illusion of strong second-quarter results back in July, many short-sellers got squeezed and were forced to cover their positions at increasingly higher prices. This pushed AMD's stock price up and up.
2) Short-Sellers Have Returned
AMD recently released fourth-quarter guidance that points to just 8% year-over-year growth during the current period. That's not aligned with the narrative that CEO Lisa Su has put out to investors -- namely, that the company is a high-growth stock.
Accordingly, we're seeing short-sellers return to the stock. The number of AMD shares sold short has jumped 5% since last month, meaning that 13% of the stock is now being sold short.
3) A Questionable Growth Rate
This brings us to AMD's growth rate. Many investors misunderstood the fact that the company's strong second-quarter results were an anomaly that management has already factored into the company's 2018 full-year guidance.
Including the top range of AMD's fourth-quarter guidance ($1.5 billion) implies that the stock will, in the best-case scenario, finish 2018 up 23%.
What's wrong with that?
First of all, CFO Devinder Kumar had been telling investors that AMD will post a mid-20% growth rate for 2018, but it turns out that this figure looks slightly ambitious.
Second, many commentators are questioning whether blockchain sales might have provided AMD with strong non-recurring tailwinds that will now turn into headwinds as the company seeks to clear its inventory channel in the crypto hangover's aftermath.
Next, while AMD's long-term financial model points to the company's top line growing at a double-digit percentage rate, few investors are asking whether this means growth closer to 20% year over year or nearer to 10%. I contend that even if AMD sees a sustainable 15% year-over-year growth rate, investors are already pricing in a meaningfully stronger growth rate than 15% CAGR.
4) Rising Debt Costs
Let's look at AMD's financial position next.
Overall, the company currently carries about $500 million of net debt. Although AMD has no significant maturities due until 2022, the company is still expected to pay back the reminder of its 6.75% notes -- i.e., those with the lowest interest rate among AMD's senior notes -- by this coming March.
Also note that AMD has weak free-cash-flow generating capabilities. By my most aggressive estimates, the company is likely to generate no more than $50 million of free cash flow.
Combine this with the fact that we've left the era of historically low interest rates and we should be mindful of the fact that AMD will need to once again raise debt to fund its operations. Worse, the company will be raising cash at more onerous rates.
5) A 400x-Free-Cash-Flow Valuation
I believe that AMD will generate $50 million of free cash flow at best for 2018, while its top line will likely sustainably grow at a 15%-20% compound annual growth rate.
But AMD currently trades at about a $23.7 billion market -- or more than 400x free cash flow. That seems like a significant overvaluation to me.
Consider AMD's rival Intel (INTC) . Intel has plenty of its own troubles -- not the least of which is the lack of a permanent CEO to guide the ship -- but INTC still trades at a much more reasonable 15x or so free cash flow.
While you could argue that AMD has significantly smaller market share than Intel does (implying more upside potential), I'd reply that the CPU and GPU markets are highly competitive -- meaning that AMD has a lot more to prove. However, AMD is the company among the two that's trading at what I see as the inflated valuation.
The Bottom Line: AMD Is Overpriced Here
Add it all up and I believe that AMD's lightly fluctuating share price gives investors the illusion of safety.
But to me, the stock's current valuation is highly inflated -- and not commensurate with either its market share or its free-cash-flow-generating abilities.