Advanced Micro Devices (AMD -1.00%) has successfully transformed itself over the past five years into a formidable player in the CPU market. The company still trails Intel in terms of market share, but the days of AMD being run over by its larger rival appear to be over.

With that success has come greatly improved profitability. Before 2017 and the first iteration of its Ryzen PC CPUs, AMD was largely relegated to the budget segment of the market. The company now competes across all price points, trading blows with Intel as it goes after gamers, professionals, prosumers, and creatives willing drop many hundreds of dollars on blazing-fast CPUs.

You only have to look at AMD's gross margin to see how far the company has come. In the third quarter of 2017, AMD managed an adjusted gross margin of just 35%. By the third quarter of this year, adjusted gross margin had risen to 50%. That's quite a turnaround.

Trouble in the PC market

Strong demand for PCs during the first two years of the pandemic helped boost AMD's revenue and push its gross margin higher. But that demand has now cooled dramatically. Global PC shipments tumbled 19.5% year over year in the third quarter, and that weakness looks like it will extend into 2023.

This sudden implosion has left PC OEMs with far too much inventory. AMD's customers are pulling back hard on orders as they aim to bring inventory levels down, leading to a precipitous drop in AMD's PC CPU sales. AMD's client segment suffered a 40% year-over-year revenue decline in the third quarter, and the segment's operating profit completely disappeared.

PC weakness led AMD to badly miss its own expectations for gross margin. The company guided for an adjusted gross margin of 54% when it reported its second-quarter results in August, but the metric fell four percentage points short of that goal.

Lower sales volumes are only part of the problem. AMD launched its latest generation of Ryzen processors earlier this year, but those chips were priced too high given the competitive landscape. Intel's Raptor Lake processors generally came out on top in terms of pure performance, and they looked even better on a price-to-performance basis.

AMD has not officially cut prices on its Ryzen 7000 series chips, but it's looking unlikely they'll ever sell at the suggested prices again. Black Friday sales brought significant discounts on Ryzen 7000 chips, and those lower prices have stuck around. AMD's Ryzen 7600X, for example, currently sells on Amazon for $240, far below the $300 launch price.

Adding to this pricing problem is a glut of last-gen Ryzen chips floating around. The top six best-selling CPUs on Amazon right now are deeply discounted Ryzen 5000 chips. On the top of the list is the high-end Ryzen 5900X, which can be had for 40% below list price at $340.

A gross margin headwind

AMD took charges of $160 million in the third quarter related to inventory, pricing, and reserves in the graphics and client businesses, which knocked down its gross margin. With last-gen CPUs still clogging up inventories, and with current-gen CPUs selling at seemingly permanent discounts, AMD's PC segment is going to be a drag on its gross margin for the foreseeable future.

Offsetting the weakness in the PC segment is Xilinx, which now resides in the embedded segment following AMD's acquisition of the programmable logic chip designer in February 2022. Prior to the acquisition, Xilinx enjoyed gross margins far above those of AMD. In its final quarterly report as a stand-alone company, Xilinx reported an adjusted gross margin of around 73%. The gross margin picture would look much worse if not for that acquisition.

AMD should report its fourth-quarter results in late January or early February. Given that demand for PCs is expected to remain weak next year, AMD's outlook for 2023, particularly the gross margin outlook, may be disappointing. The company will lap its Xilinx acquisition early in the year, eliminating the one-off boost to its revenue growth rate, and pricing pressure in the PC segment could lead to more write-offs and depressed profitability.

At least for now, the era of ever-rising gross margins for AMD appears to be over.