As the East Coast was brewing coffee Monday morning, Advanced Micro Devices (NYSE:AMD) was announcing a plan to acquire graphics-chip maker ATI Technologies (NASDAQ:ATYT) for $5.4 billion, or $20.47 per share, in cash and stock. It was billed by AMD as huge news, another mighty blow for the little guy. Investors, however, were having none of it; AMD shares were off more than 4% on a day that saw the Dow up 1.6% and the Nasdaq up more than 2%.

Left at the altar
What gives? My guess is that investors didn't like the structure of the deal, especially since it saps AMD of much-needed moola to fund a price war with rival Intel (NASDAQ:INTC). All told, the upstart chip maker will pay $4.2 billion in cash, drawing down the $3.3 billion in its bank account to zero, then refunding it with $2.5 billion in financing from Morgan Stanley (NYSE:MS).

Normally, I'd applaud this approach. Dilution is being held to a minimum, while AMD adds needed elements to its product portfolio. But there will be only one hand clapping this time. Cash flow is too much of a concern:

Free cash flow*


















Source: Capital IQ
* Numbers in millions

Only recently has AMD produced generous free cash flow, which could be fleeting with the looming price war. Now, to be fair, the vast majority of these years includes Spansion (NASDAQ:SPSN) as an AMD business unit. But the point remains that neither AMD nor ATI has a history of producing hefty FCF, and now they'll be called upon to service what appears to be at least $2 billion worth of debt.

Trouble in paradise?
Still, there's a lot to like about this deal. First, ATI and NVIDIA (NASDAQ:NVDA) are the biggest players in the high-growth graphics chip market. Second, ATI and AMD already work together; 30% to 40% of the revenue ATI earns from computer makers is tied to AMD processors. Third and most important, AMD gains technology to fill out its portfolio in enterprise and consumer mobile and desktop PCs.

You see, unlike Intel, AMD doesn't have an integrated graphics processor for its enterprise and consumer PCs. ATI has filled that role, for the most part. But the approach, while offering choice to manufacturers, has produced a key drawback: The ATI chip must travel through an AMD processor to access the memory needed to execute commands. Intel's graphics chips, on the other hand, sit right next to a memory controller, leaving the CPU free.

Jim McGregor, chip analyst with researcher In-Stat, expects ATI to help AMD address the problem. If he's right, performance would improve dramatically, which in turn would make AMD far more competitive in markets where Intel has been dominant, such as notebook PCs. Executives salivate at that possibility, telling analysts that the deal could produce hundreds of millions in value by 2008, and billions in value beginning in 2009.

That may very well be, but I think it's most important to notice the timeframe. As McGregor told me, AMD won't roll out its new mobile architecture before next year. When it does, there's every reason to expect the company to creatively leverage ATI. Till then, at least in the mobile space, the upstart chip maker is likely to remain an upstart.

A long, happy marriage
I'm never one to applaud panic selling, but I'm not sure that's what happened with AMD's shares yesterday. Instead, I believe that some investors expressed real concerns for a potentially expensive deal that could take years to pay off.

Nevertheless, the price may be worth it. As McGregor says, "[the deal] buys them a greater market presence than NVIDIA would have." That's because ATI supplies chips to Microsoft (NASDAQ:MSFT) for its Xbox 360 system, as well as processors for cameraphones and other consumer electronics. AMD has no standing in those markets today, and wouldn't for many years without ATI's help. But now it may finally have enough to match Intel as the two vie to provide the electronic brains for everything that connects to a network. If that day ever arrives, historians may conclude that AMD's current cash crunch was just the catalyst it needed.

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For years, Fool contributor Tim Beyers has been using ATI chips in all his family's Macs. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Fool profile. The Motley Fool has an ironclad disclosure policy.