This Small Chip Stock Is Up 200% in a Year on AI Hype

Here's some more AI stock madness for you: Memory chip technology patent holder and licensor Rambus (RMBS 1.91%) is up 200% over the last 12-month stretch, driven most recently by hype surrounding new memory protocols needed for data center hardware and AI. 

This was confounding to me, as I'm (just barely) old enough to remember Rambus' checkered past. From the early 2000s through the early 2010s, the company earned a reputation as a patent troll. Rambus seemingly turned over a new leaf, and some investors are optimistic for the intellectual property (IP) portfolio in a new era for AI. Is Rambus stock worth your money? 

Dispensing with old trolling practices

These days, Rambus makes the vast majority of its money from memory interface chips. The company also licenses its IP portfolio for various other memory and security technologies that companies use in designing their own chips. 

Data source: Rambus. 

Highlights in recent quarters include Rambus renewing its previous 10-year partnership with top memory chipmakers SK Hynix and Samsung in South Korea. This is a refreshing development considering Rambus settled with both companies a decade ago over Rambus' allegation that its chip patents were being infringed upon. Other companies that had come into Rambus' crosshairs in the 2000s included Micron and Nvidia. Its reputation as a patent troll seeking large royalty payouts also attracted attention from the Federal Trade Commission (FTC), which levied several lawsuits against Rambus.

Since those early-2010 settlements, Rambus has become a less controversial company, and has taken a more collaborative approach to working with its partners. 

New memory for a new era of AI

What's with the sudden surge in Rambus' stock price? A couple years ago the memory chip market signaled a coming upgrade cycle for enterprise and data center-grade systems. This upgrade cycle from DDR4 SDRAM to DDR5 SDRAM is now underway. ("DDR" standing for "double data rate," the number signifying the generation of this technology, and "SDRAM" standing for "synchronous dynamic random access memory".) 

In layperson's terms, this interface tech upgrade to DDR5 roughly doubles the amount of data per second that can be transferred with less energy use -- like from memory to a processing chip, for example a GPU designed by Nvidia running through massive amounts of information to train an AI system. Think of these parts from Rambus as a type of highway that runs between a computer's memory and a processor. 

Rambus' DDR5 memory interface chips. Image source: Rambus.

There's a robust upgrade cycle expected to continue into 2024 and possibly beyond. Memory semiconductor designers and manufacturers are increasing their production for data center high-performance computing, including for new AI workloads. Optimism has been building that Rambus can make hay from its DDR5 interfaces, with a nice addition coming from its income from patent royalties. Indeed, for the last year and a half or so, Rambus has been building momentum, and has used its free cash flow to fully pay off its debt.

Data by YCharts.

Time to buy?

This transition to new memory technology will be very lumpy, though. For example, in Q2 2023, management said it expects product sales to fall from the previous quarter's level to $53 million, royalties to increase to $40 million, and contract revenue to increase to remain roughly stable at about $21 million (all numbers at the midpoint of guidance). In all, revenue is forecasted to flatline from Q1 to Q2 2023.

Nevertheless, based on assumptions that a lot more memory interface chips will be needed in data centers and AI systems, investors have run up Rambus stock's valuation. Free cash flow has doubled over the last five years. But the premium on the stock has also doubled too. What was once considered a fair value of mid-teens price-to-free cash flow has now been driven to over 30 times free cash flow. 

I'll admit, it appears Rambus has turned over a new leaf. It's in good financial shape, could enjoy some mid-teens percentage growth over the next few years from the data center AI hype going on, and seems to be a much friendlier business than in times past. Perhaps Rambus is deserving of attention. However, with a lofty valuation for this particular business model, I'm avoiding the stock right now.