Thursday, October 19, 2006

Color on quarter: AMD (NYSE:AMD)

Several firms are commenting on AMD (NYSE:AMD) after disappointing results announced yesterday. I see at least one downgrade:

- Merrill Lynch notes AMD is still taking unit share away from Intel, but is doing it at the cost of pricing and margins. What's happening here is that AMD is continuing to add output at the same time that Intel has freshened its own product offering and supported that with plenty of capacity and even more inventory. The result is a battle to keep fabs full.

Looking into 2007, firm's preliminary work suggests that Intel and AMD are going to add wafer capacity at a rate between 15% and 17%, with AMD citing a target of more than 30% on the conference call yesterday. That for an end market that might grow at 10% if the Vista upgrade cycle materializes. They think that 2007 is likely to turn into a contest between the two processor makers to see who can weather the most financial pain. AMD, unfortunately, has just levered up its balance sheet and reduced its ability to weather pain with purchase of ATI.

Long-term share gain potential is still there, and at a likely opening price of $21 or $22 today the firm doesn'tthink that the stock is likely to decline much further. Making money on the stock for the next twelve months is going to be difficult, though - especially once ATI is wrapped in, AMD will be lucky to show $1.00 in earnings next year. The stock looks fully valued.

- Goldman Sachs notes downside to their EPS estimate was caused by a significant shortfall in gross margins (51.4% versus firm's 58% estimate), which was primarily attributable to weak ASPs in the desktop segment.

Firm believes AMD's report reinforces their long-held view that investors should not own cyclical stocks at historical peak margin levels, as margins have declined for several quarters after reaching previous peak levels in late 2005, and the stock has declined accordingly. They would not establish short positions in AMD given what is likely to be a significant sell-off in the stock post earnings, and they would not establish long positions in Intel (Neutral) given the recent run-up in the stock. However, the firm continues to recommend a long Intel/short AMD pair trade, as they believe Intel is better positioned entering 2007 given its competitive new products and improved cost structure. Firm is concerned that AMD's debt and depreciation are ramping significantly in 2007, which raises the bar for execution. Yet, many factors outside of the company's control could negatively impact its P&L, including a difficult pricing environment like we saw in CY3Q2006.

Firm sees about 20% downside to our 12-month price target of $19.

- Prudential is the only bull of the bunch noting this quarter, investors were reminded that AMD competes with a well- capitalized Goliath that spends 4x what AMD does on R&D and is benefiting from a refreshed product cycle.

Near term, they think that the recent gross margin miss and the risk associated with the pending ATYT acquisition will limit the opportunity for P/E multiple expansion...

However, given the disappointing quarter, and that they can find few investors who anticipate a smooth integration with ATYT, it seems that sentiment could be at a nadir. Assuming a successful integration with ATYT, at $20, the combined entity would be trading at an EV/Sales ratio of 1.3x, the lowest level of any stock in firm's universe of coverage, suggesting limited downside from that level.

Conversely, the long term upside potential is compelling - AMD appears to have smashed Intel's stranglehold on the PC MPU market. With competitive products and capacity, AMD may well be on its way from 20% to 50% of the market.

Firm thinks AMD trades between $20 and $25 in the intermediate term, and remains Neutral Weight the stock.

Notablecalls: There is no trade here. What would you pay for a stock that has maybe $1.00 EPS power and is bound to face one heck of a fight with a Goliath that has net profit the size of it's opponents revenue. Would you pay 20x? Or maybe 15x?

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