Advanced Micro Devices (AMD 1.86%) stock has rallied strongly in 2023 and gained nearly 50% as of this writing, which explains why shares of the chipmaker are now trading at a substantially rich valuation even as the company faces headwinds in key areas.
More specifically, AMD is now trading at a whopping 114 times trailing earnings, which is well above its five-year average price-to-earnings ratio of 89. Of course, there are a few reasons why the chipmaker may be able to justify its rich valuation and deliver more upside, but does it make sense for investors to buy this semiconductor stock at its current multiples, especially considering the challenges it is set to face? Let's find out.
AMD investors shouldn't miss this obvious red flag
AMD's first-quarter 2023 results are still a month away, but there is a big headwind that investors should note, as it could bring the company's hot stock market rally to an end. Weak sales of personal computers (PCs) weighed heavily on AMD's financial performance in the fourth quarter of 2022, leading to a 51% year-over-year revenue decline in the client segment.
AMD reported $903 million in client segment revenue during the quarter, blaming "reduced processor shipments resulting from a weak PC market and a significant inventory correction across the PC supply chain" for the segment's terrible showing. The segment produced 16% of AMD's total revenue during the quarter, and it could report another woeful performance when the company releases its Q1 2023 earnings report.
That's because the PC market is not expected to recover in 2023, according to market research firm IDC's latest report. IDC is forecasting a 10.7% decline in PC shipments this year to nearly 261 million units. It was earlier anticipating a smaller drop of 5.6% to 281 million units. As a result, the inventory correction issue that plagued AMD's client processor business in the fourth quarter of 2022 could keep AMD from meeting its Q1 2023 forecasts.
The company's guidance calls for $5.3 billion in Q1 revenue, a 10% decline over the year-ago period. Also, a weak PC market could weigh on AMD's guidance for the second quarter and the rest of the year as management was expecting this business to hit bottom in Q1 and "then grow from there into the second quarter and then into the second half."
So it won't be surprising to see investors hit the panic button if AMD's guidance numbers don't match up to Wall Street's expectations in the near term, thanks to the persistent weakness in the PC market. But that's not the only red flag to watch for.
Nvidia could spoil AMD's data center party
The data center business has been doing the heavy lifting for AMD in the past year and helped mitigate the weakness in the client processor business to a large extent. In the fourth quarter of 2022, for instance, AMD's data center revenue shot up 42% year over year to $1.7 billion thanks to the healthy demand for the company's Epyc server processors.
The segment produced 30% of AMD's total revenue. A key reason why AMD has been clocking terrific growth in server processors is because of its market share gains against Intel. AMD expects to win more share in the server processor market this year, but Nvidia's (NVDA 1.84%) entry into this market could play spoilsport.
Nvidia is claiming that its Arm-based Grace server processors that are set to hit the market this year could significantly outperform processors based on the x86 architecture that AMD and Intel sell. Given that Nvidia has tied up with multiple OEMs (original equipment manufacturers) that are going to make servers using its Grace processors, it may be able to dent AMD's progress in this market.
Moreover, the share of Arm server processors is expected to increase at a nice clip in the coming years. Market research firm TrendForce expects Arm-based servers to account for a 22% share of the data center market by 2025, which would be a big increase over last year's estimated share of 6.8%. So, Nvidia's arrival into the server processor market with its Arm-based chips could prove to be a long-term headwind for AMD.
All this indicates that AMD may find it tough to justify its rich valuation, and the company's first-quarter 2023 earnings report could give investors a reality check. That's why investors who are looking to jump onto the AMD bandwagon may want to exercise caution and see how the company is navigating the difficult PC market environment and intensifying competition in server CPUs.
