Lingering Questions Plague AMD's Semi-Custom Ambitions

The centerpiece of Advanced Micro Devices' (NYSE: AMD  ) turnaround strategy is its push into semi-custom SoC design. Both major game consoles, Sony's (NYSE: SNE  ) PlayStation 4 and Microsoft's Xbox One, are powered by AMD's chips, and those deals have given the company a big new source of revenue that has helped counteract weakness in other segments. But, can the semi-custom business deliver the kind of growth investors are expecting?

Consoles are not enough
Game consoles have provided AMD with the ability to return to profitability, even as its PC business continues to decline. During the second quarter, the graphics and visual solutions segment, which contains GPUs and the semi-custom business, generated $82 million in operating profit on $772 million of revenue. This segment is now larger than the computing solutions segment, which includes AMD's struggling PC processor business.

During the second quarter of 2013, before the launch of the game consoles, AMD recorded an operating loss of $29 million. This turned into an operating profit of $63 million during the second quarter of this year, driven almost completely by profits from the semi-custom business.

Sony's PlayStation 4, in particular, has been selling extremely well, with VGChartz putting PS4 sales through July 12 at 8.6 million units, far more than the 4.9 million units for the Xbox One. Previous generations of game consoles were powered by CPUs based on the Power architecture, with separate graphics units, but this time around, Sony wanted an SoC with everything integrated into one chip, much like the processors powering smartphones. This would lead to lower power consumption, and once the choice of the x86 architecture was made, AMD was the only company able and willing to deliver.

The game consoles alone aren't enough to make AMD a good investment, however. Operating income for the first half of 2014 was $112 million, and with console sales weighted toward the second half, this number could more than double for the full year.

If AMD manages $300 million in operating income for the full year, interest payments will knock this down to about $130 million. Ignoring non-cash charges and lopping off 35% for taxes, non-GAAP net income would come out to roughly $85 million. A market capitalization of $2.9 billion, after the recent post-earnings collapse, puts AMD's P/E ratio at about 34 using this estimate.

Plenty of uncertainty
Profits from game consoles can certainly grow over the next few years, but they will eventually begin to decline, so AMD needs to win enough new semi-custom designs to both make up for this decline and justify its valuation. The problem is that there is a lot of uncertainty surrounding the semi-custom business.

During AMD's recent conference call, the company stated that it expects to announce one or two semi-custom wins in 2014, and the target range is $250 million-$500 million in lifetime revenue per deal. The company cited a growing pipeline of deals, but since these are typically confidential, announcements from AMD will likely come well after the business is actually won.

The lifetime of these deals is unknown, but given that game consoles have lifespans between 5-10 years, if other semi-custom deals are similar, it's going to take an awful lot of design wins to have any real impact on the bottom line. The one or two design wins that will be announced later this year could add as much as $1 billion in revenue for the company, but if this is spread out over five years, and operating margin is around 10%, that's only $20 million in additional operating profit annually. That does little to bring down a sky-high valuation.

The bottom line
The biggest problem with the semi-custom story that AMD is selling investors is that it's difficult to tell the size of the opportunity. Future deals will be far smaller than the game console deals, and the pace and lifespan of those deals will have a huge impact on results. Even at the current depressed stock price, a significant amount of earnings growth is baked in, and it's unclear whether the semi-custom business can actually deliver this growth.

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  • Report this Comment On July 24, 2014, at 1:57 PM, foolishfun4me wrote:

    Are you sure that "lopping off 35% for taxes" is correct? The last AMD 10-K says they have $1.7 billion in NOL carryforwards which are fully covered by over $3 billion in valuation allowances. Said another way, AMD will pay next to no income taxes on its next $1.7 billion in pretax income.

  • Report this Comment On July 24, 2014, at 3:43 PM, binartech wrote:

    Intel strategy is pure commercial, illegal, contra revenue, EU court confirmed that Intel was monopolizing the market with illegal proactices.

    This gave 10 billion advantage to Intel Over AMD.

    Of course SEMI custom is not enough you do not have to be brilliant to notice that.

    AMD has a rough time but it will break out

    continue bashing AMD.

    what doesn't kill you makes you stronger

  • Report this Comment On July 24, 2014, at 4:43 PM, chrispycrunch wrote:

    (AMD) will fight hard to hold the $3.75. If so, look for $4 within a month. My $6 target by end of year does not change.

  • Report this Comment On August 01, 2014, at 4:58 AM, rav55 wrote:

    Your entire piece is pure speculation as there are no facts to base anything upon.

    Semi-custom is also proprietary and by necessity held close to the vest. What was amusing was your insistance that the life of the product was too long to be of any import to the bottom line.

    Why don't you speculate the opposite? Could it be that does not agree with the premise that you are fabricating.

    The consoles have at least 3 more years of steady income and quite likely an APU refresh which which will stimulate additional growth and extend to life out to 10 years. The addition of the China market for XBOX regardless of the reseller's entry point will also see additional income. And Sony I am sure is not going to ignore China either. That market is huge! The Jaguar fab process is also mature and yields have to be increasing improving margins on console silicon as well.

    The consoles are better than a PC in that the console is dedicated to entertainment. And console owners are also PC owners as well. Why tie up a PC for entertainment when for a few hundred dollars you can buy a console to play games on the flat screen.

    Performance aside, the console is hands down a better buy.

    If you are so worried about loss of income then you should divest nVidia as it loses $250 million per year when the Intel nVidia cross license agreement ends. When is that again?

    AMD is now profitable, making money and showing growth. Hardly a scenario to run around declaring that the sky is falling.

  • Report this Comment On August 01, 2014, at 5:02 AM, rav55 wrote:

    @crispycrunch

    If AMD shows $0.12 earnings at year end with Microservers looking good moving forward then $6 is a very real number. Maybe not support at $6 but definitely highs of $6.

    $3.80 is the support levels and if AMD keeps executing as it is then the shorts should push it back up towards $4.7-$5. AMD will be next reporting for Christmas OEM channel and the consoles are seeing growth into new markets.

  • Report this Comment On August 07, 2014, at 8:26 AM, rav55 wrote:

    There is an acquisition rumor that Samsung is in talks to buy AMD. This could explain why AMD has been quietly climbing for the last few sessions.

    Here: http://sierraworldequityreview.blogspot.com/2014/07/low-hang...

  • Report this Comment On August 07, 2014, at 8:33 AM, rav55 wrote:

    It also might explain why Samsung dropped there own in-house ARM server program.

    The Radeon brand plus ARM silicon as well as x86 license just might make AMD a very cheap take-over candidate.

    It would also be the catalyst for the Mother of all short squeezes!

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