Semiconductor stocks have been a good place to invest in recent years, but it's been a rough start to 2022. The PHLX Semiconductor Sector index has dropped 8.1% year to date, while the Nasdaq Composite has performed a bit better, down 6.1% at the time of writing.
Some investors are concerned about companies that depend on Taiwan Semiconductor Manufacturing for foundry services, which include many of the leading chip stocks. The Ukraine-Russia war has some investors thinking ahead to what a Chinese takeover of Taiwan would do to the supply chain, including Advanced Micro Devices (AMD 0.19%).
Other investors are concerned that AMD is at the end of a growth cycle and could see demand weaken over the next few years. But I believe there is a stronger argument to be made that AMD is still a stock worth holding for the long term. Here are three reasons why.
1. AMD's valuation is reasonable and getting better
AMD has been a terrific stock to own since CEO Dr. Lisa Su took over in 2014. The stock price is up 4,500% over the last seven years, but its current valuation could look like a bargain after another five years' worth of growth in the business.
The stock's price-to-earnings (P/E) ratio currently stands at 48 based on 2021 earnings results. However, using the consensus analyst estimate for 2022, the P/E drops to 30. It gets even cheaper the further out you project growth.
Analysts expect AMD to grow earnings at a compound annual rate of 30% over the next five years. That would put AMD's earnings per share at $10.36 at the end of 2026, so investors are basically paying about 12 times what AMD could report in earnings in five years. If the stock trades at 20 times five-year projected earnings, investors could nearly double their money.
So, what is baked into analysts' growth estimates?
2. Xilinx acquisition and management's guidance point to growth
AMD just closed its acquisition of Xilinx, a leading supplier of programmable chips that help support a more connected world from the data center to the edge. The market opportunity across cloud, edge computing, and intelligent devices is estimated at $135 billion. The deal is expected to be accretive to AMD's margins, earnings, and free cash flow this year.
Other than Xilinx, AMD expects another year of strong growth. "Demand for our product is very strong, and we look forward to another year of significant growth and share gains as we ramp our current products and launch our next wave of Zen 4 CPUs and RDNA 3 GPUs," Su stated during the fourth-quarter earnings call.
Excluding revenue from Xilinx, previous guidance called for revenue to increase by approximately 31% this year to $21.5 billion. The company doesn't provide specific earnings guidance, but management expects continued improvement in AMD's gross margin, which implies that earnings should grow faster than the top line. This leads to the final reason why AMD could surprise the bears.
3. AMD's margin is expanding
One of the reasons why AMD stock has risen so much is improving profitability. AMD was unprofitable when Su stepped in, but the company's profit margin has improved to nearly 20% through 2021.
Investors are underestimating AMD's opportunity to keep expanding profit margin and fuel further growth in earnings. For example, AMD's rival Nvidia has a profit margin of 36%. Given that wide gap and AMD's progress so far, investors should expect management to continue steering the business into lucrative markets that can improve profitability further. This explains the rationale for the Xilinx acquisition.
Management's guidance calls for gross margin to improve to 51% this year, up from 48% in 2021. It might be even higher with the addition of Xilinx, which has better margins than AMD.
The key catalyst to higher margins is the strong demand for data center processors, which is a high-margin market for AMD and where it continues to see momentum. "We exited 2021 with data center revenue contributing a mid-20 percentage of overall revenue, and we expect 2022 to be another year of significant growth based on the strong customer demand signals for our current and next-generation products," Su said on the Q4 earnings call.
AMD is a solid investment
AMD is selling for a reasonable valuation relative to underlying growth. Revenue is expected to increase about 31% in 2022 (excluding Xilinx), and robust demand for high-margin processors should keep earnings growth strong, too.
Companies are using artificial intelligence to distill insights from the steady accumulation of data, which is underpinning the growing demand for advanced processors. This trend largely explains management's bullish guidance and could sustain AMD's growth longer than the bears expect.