AMD (NASDAQ: AMD) pre-released third quarter results on October 6, 2022, sadly shortly after I wrote “AMD: Buy when others are scared”. AMD’s pre-release is pretty big when it comes to revenue size decline the semiconductor company experienced in the third quarter due to further deterioration in the PC market. While I think AMD has long-term potential, partly tied to the huge metaverse opportunity and AMD’s very successful EPYC series of data processors, I think the short-term uncertainty and lower expectations will weigh on AMD for some time. The decline in gross margins is a game-changer as it signals the end of the current boom cycle in the chip industry. For these reasons, I modify my recommendation and maintain it.
AMD pre-released Q3’22 results
On October 6, 2022, AMD released its third quarter 2022 results three weeks early due to a major deterioration in operating conditions in the third quarter.
AMD disclosed in a Release that its third-quarter revenue was just $5.6 billion, $1.1 billion below the median forecast just a quarter ago. Three months ago, AMD was forecasting revenue of $6.7 billion +/- $200 million, primarily due to rapidly declining growth in the Client segment. The Customer segment is a new reporting section for AMD that includes the sale of Ryzen processors for desktops and laptops. Demand for processors declined in fiscal 2022, largely because PC shipments plummeted after the COVID-19 pandemic saw device sales hit a record high in the first quarter of 2021. Since then , however, shipments of PCs, laptops and mobile devices fell sharply. According to the latest PC shipment data just released by consulting firm Gartner, PC shipments fell significantly in the third quarter, which is tied to AMD’s earnings warning.
According to Gartner, PC shipments fell by a massive 19.5% in the third quarter which represented the biggest drop since the mid-1990s, indicating that the PC/laptop market is in much worse shape than expected. According to Gartner’s earlier outlook, the company forecast a 9.5% drop in PC shipments in fiscal 2022 and a 7.6% drop in total device sales (including mobile phones). The latest data from Gartner combined with AMD’s earnings warning, however, paints a pretty grim picture of the state of the PC and device markets and things could even get worse for AMD in the near term.
From Lenovo to Apple, major PC and laptop makers saw significant declines in PC shipments in Q3’22, indicating that the slowdown is as broad-based as it is significant.
Weakening demand for PCs was cited by AMD as one of the main reasons for the slump in revenue growth in the Client business. However, AMD’s third-quarter 2022 revenue of $5.6 billion still represented 29% year-over-year growth, and the company’s other segments, particularly data centers, continued to perform well for AMD. The Data Center business has consistently delivered 45% year-over-year revenue growth and has a new quarterly revenue base of $1.6 billion. But clearly growth is slowing sharply for AMD and this has already created significant headwinds for AMD’s valuation.
Gross margins under pressure: the end of the stock market cycle
Due to the slowdown in customer activity, AMD is seeing declining gross margins…which I previously referred to as the canary in the chip company coal mine. Indeed, the contraction in gross margins is the result of lower prices and strong volumes, which is clearly the case here. AMD disclosed a 50% (non-GAAP) gross margin for the third quarter, which is lower than the 54% gross margin expected in AMD’s previous outlook. I think AMD’s gross margins (in %) have now effectively peaked and may be poised for another sequential decline in Q4’22 if the PC market continues to weaken.
Revisiting AMD’s Valuation – Estimating Risk
AMD has a much more compelling valuation now after the earnings warning sent stocks plummeting. I still believe AMD has an attractive long-term growth curve due to its aggressive investments in data centers and the recently closed acquisitions of Xilinx and Pensando. However, AMD now has significant estimate risk and analysts have already started to cut their projections for the company’s earnings for fiscal 2022 and 2023.
AMD is now selling at its lowest PE ratio in a year, but with falling EPS estimates, the PE ratio could rise significantly in the future.
The obvious risk after AMD’s earnings warning is that AMD’s gross margins will continue to decline in the coming quarters, effectively ending the current semiconductor expansion cycle. Additionally, AMD is expected to face downward pressure on its average selling prices, especially in consumer-oriented customer and gaming businesses. High prices for processors and especially graphics processing units led AMD to post record results last year and weaker prices at a time when volume shipments are contracting indicate that AMD’s gross margins will continue likely to decline in the short term.
The timing of my last article was quite unfortunate. While I like to buy a quality company at a decent valuation – which AMD offers – I also have to acknowledge the changing operating conditions that have led Gartner and AMD to release some very concerning new information lately. I think AMD’s earnings warning is a game-changer, especially the decline in gross margins, and I’ve unfortunately overestimated AMD’s potential in my latest work.
If the PC market slows further in Q4 22, which I expect, AMD should see a continued decline in customer revenue. What is even more concerning is that AMD’s gross margins have started to decline and pressure on average selling prices is building. For these reasons, I have to downgrade AMD to pending!