Can Game Consoles Save AMD?

Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Amidst mounting losses and debt, Advanced Micro Devices (NYSE: AMD) appears to be all but finished, but big wins for AMD processors on future gaming consoles from Sony (NYSE: SNE) and Microsoft (NASDAQ: MSFT) may turn things around. 

The bear case for AMD

Many, including fellow Motley Fool blogger Leo Sun, have presented the bear case for AMD, so I won't belabor it. Suffice it to say that just about everything went south for AMD in 2012.  Annual revenue declined 17% to $5.422 billion compared to 2011, while the company racked up a huge operating loss of $1.056 billion.  Meanwhile, AMD's long term debt increased 33% to $2.037 billion, while its cash reserves decreased 43% to $1.002 billion. AMD's PC processor market share, once as high as about 50%, is thought to have declined to about 17%. 

AMD's market share declines are a reflection of the fact that AMD's highest performing products generally trail the highest performing products of its competitors in performance ratings.  For this, I like to rely on results shown by Passmark Software on their website, where they publish average results of thousands of users of their Performance Test utility.  AMD processors generally rank lower than Intel in the High End CPU classification, and AMD's Radeon graphics cards generally rank lower than their main competitor, NVidia, in the High End GPU classification.   

Given that AMD seemed to be losing on all fronts, the reports that AMD processors had been chosen for the next generation Sony Playstation and Microsoft Xbox consoles peaked my curiosity.  AMD and Sony have confirmed that AMD will be in the Playstation 4, and the rumors about a similar processor in the next generation Xbox 720 appear highly credible.  What about the AMD processors made them attractive for consoles?  More importantly, what would be the impact to AMD's bottom line?

Two wrongs make a right

The PS4 and future Xbox use what AMD calls Accelerated Processing Units (APUs) that combine a 64 bit Intel compatible multi-core CPU with a graphics processing unit (GPU) based on AMD's Radeon line of discreet GPUs.  Since Intel is including GPUs in its latest Ivy Bridge processors, you might wonder what's so special about AMD's APUs.  The answer is that the graphics performance of the APUs is about equivalent to a separate mid-grade graphics card, whereas the HD4000 graphics performance in the best Ivy Bridge processors is not nearly as good.  This was confirmed in a recent AnandTech review of an APU (the A10-5800K) intended for desktop use. 

In fact, the internal Intel graphics is acceptable for casual use but not really suited for immersive, high definition gaming.  I've personally verified this on my Intel Ivy Bridge Core i7 3770K system.  For games like Crysis 2, played at 1080p resolution with graphics settings at maximum quality, the HD 4000 graphics frame rate was about 6 frames/sec, too slow to be usable. 

So what AMD has done with the APU is combine a mid-grade CPU and a mid-grade GPU, which would be the wrong answers for serious PC enthusiasts wanting the very best performance, into a system-on-chip (SOC) that turns out to be the right answer for console manufacturers.

The future of consoles

But aren't consoles on the decline? True, sales of consoles have slowed, but I think this is due to the very long time since the current Xbox and Playstation consoles were introduced in 2005-2006.  Also, PC performance has largely eclipsed current consoles for gaming, making them even less attractive.

I expect the next gen consoles to tap into some pent up demand, as well as find a place in the mobile device centric life style.  As powerful as mobile devices have become, they don't provide enough graphics horsepower to run the most demanding games, nor will they for the foreseeable future.  Consoles can fill the performance gap between mobile devices and PCs for gaming. 

Console makers have also added much PC functionality in an effort to make consoles even more attractive as PC substitutes, including HD movie playback and download, and Internet connectivity to online content stores and social networking.  For many consumers with smartphones and tablets, the console may be the only non-mobile computing asset they need or want.

The console bottom line

Can the console business make AMD profitable again?  Probably.  To analyze the question I put together a “what if” spreadsheet model to calculate the impact of console APU sales to AMD's bottom line.  The table below summarizes the results:

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For next gen game consoles to arrive on store shelves in time for the holidays, AMD would need to start manufacturing console APUs in Q2, so the above model looks at Q2 compared to 2012 Q4, the last quarter for which I have AMD data.  I apply the best current guess of AMD market share to estimate unit sales of AMD PC chipsets.  From this I get an average selling price. For the ASP of the console ASUs, I discount the chipset selling price by 25%. 

For console sales volume I use the historical sales figures for Xbox 360 and Playstation3 of 75.9 and 77 million, respectively.  This works out to an average sales rate of about 10 million units/year for each platform, and then I assume that sales of the next generation consoles will do at least as well.  With an average APU selling price of $40, this could contribute about $800 million a year in revenue.  Given a projected further decline in PC sales, this could add as much as 30% to AMD's Computing Solutions revenues.

The gross margin in 2012 Q4 deteriorated badly to 21.47% largely due to renegotiated supply contracts with Global Foundries and inventory write-downs.  AMD management has stated that they expect the gross margin to return to 41%, so this is the margin I assumed.  Although it certainly appears that AMD's Computing Solutions segment could return to profitability based on improved gross margin and the revenue stream from console APUs, I don't try to project operating income, but I may be able to do this once I look over AMD's 2013 Q1 results. 

There are still many unknowns, not the least of which is whether or not AMD's overall PC chipset sales will continue to deteriorate and how fast.  But the console wins are big and could make the difference for AMD in 2013 and beyond.  If you're looking for a high risk/high return turnaround investment, AMD might be the one.  After AMD's earnings report on April 18, I'll revisit the model and try to close out some of the remaining unknowns. Stay tuned. 

Mark Hibben has no position in any stocks mentioned. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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