Few fields move as rapidly as technology. Businesses creating outsized profits and returns for shareholders quickly get a bull's-eye painted on their back as they become targets of other companies looking to disrupt their products by selling cheaper alternatives that still prove "good enough." Not only that, but even if a company continues to dominate its particular field, other changes in technology can shift spending away from their products. Think about how Microsoft still dominates PCs but feels pressure from the sales shift toward mobile devices such as smartphones and tablets.

With that in mind, today we're looking at how Advanced Micro Devices (NYSE: AMD) innovates. 

Technology companies can innovate either through acquisitions or by spending more money on research and development. We'll compare AMD's spending in these areas with that of its closest peers and assess whether the company is investing enough in its future.

Research and development
Over the past five years, AMD has spent an average of 27% of revenues on R&D. The following table summarizes how AMD's R&D expenditures relative to revenues compare with some of the company's closest peers.

Company

2006

2007

2008

2009

2010

LTM

AMD 21.1% 30.2% 31.8% 31.9% 21.6% 22.2%
NVIDIA 18.0% 15.9% 25.0% 24.6% 24.0% 24.6%
Intel 16.6% 15.0% 15.2% 16.1% 15.1% 15.0%

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period.

AMD spends significantly more than Intel does on R&D as a percent of total sales in its attempts to keep up with the 800-pound gorilla of processors. However, Intel's huge size means that in absolute terms, its R&D spend is 4.8 times higher than AMD's. This need to pour such an outsized amount of revenues into R&D is part of what makes it so difficult for AMD to stay profitable. In 2008, for example, its R&D expense as a percentage of sales was double Intel's. That's another 15 percentage points of expenses that prevent sales from flowing to the bottom line as profits.

During the recession, AMD ramped back on R&D, a decision that could present long-term challenges. The company is still spending below its five-year R&D average. In addition, the company's lessened resources mean it must focus more on specific projects, such as its Fusion technology that melds the central and graphics processor onto a single die, whereas Intel is freer to pursue varying technologies that might have longer-term payoffs. A key example would be Intel's "Tri-Gate" technology, AMD is years behind in bringing 3D transistor technology to the market. Another area that AMD has underinvested in is mobile. As of right now, AMD doesn't have any presence in the booming smartphone space.

Acquisitions 
In technology, some of the best companies have turned growth through acquisitions into an art. IBM has adeptly spun off capital-heavy businesses such as the hard-drive and PC segments, while it focused on acquiring additional services and software expertise that have transformed its business model.

On the opposite end of the spectrum, Hewlett-Packard is often criticized for underinvesting in R&D, to the point that it has to overpay on acquisitions to catch up with its competitors.

Investors should remember, most of all, that companies are valued by the cash flow they can bring in for their shareholders over time. If companies need to continue making purchases in perpetuity to keep growing, that amounts to a reduction in cash flows, and investors should treat acquisition spending as a continuing outflow against cash flow.

Let's take a look at AMD's free cash flow over the past five years against cash spent on acquisitions.

G

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period.

Aside from its acquisition of ATI in 2006 to get into the graphics space, AMD isn't overly acquisitive. Innovation comes from internal R&D. Looking at cash flows, we see that the company used to have massive capital expenditure outlays but has since spun off its manufacturing arm, so in the future, free cash flows should closely align with total operating cash flow, as capital-expenditure requirements are minimal. 

Final thoughts
With the rollout of its new chip architectures across the coming year, AMD should be in its best competitive position in years during 2011. However, with a board that doesn't like the company's mobile positioning, it wouldn't surprise me if AMD was either forced to ramp up R&D to catch up in the space or attempted to make some kind of acquisition. The company isn't exactly in the best financial state to make a purchase, but maybe something along the lines of NVIDIA's recent acquisition of Icera could be in the cards. With Qualcomm seeing success in combining wireless connectivity products into its mobile processors, Intel paying up for Infineon's wireless unit, and NIVIDIA recently making a purchase, AMD might look to add a smaller wireless component itself -- that is, if the company decides to get serious about competing in mobile devices.

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Eric Bleeker owns shares of NVIDIA. The Motley Fool owns shares of Microsoft, Qualcomm, and IBM and owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Intel, NVIDIA, and Microsoft, writing puts in NVIDIA, and creating diagonal call positions in Intel and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.