An Attractive Semiconductor

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

The last year has been tough for the PC industry. The industry showed negative growth for the first time in nearly a decade, and everyone is now questioning whether we're at the end of the PC era -- and if stocks dependent on the PC industry have any future at all.

The fall of one of the biggest industries in the world has had an impact on a number of companies, but PC semiconductors and OEMs (Original Equipment Manufacturers) are the ones most affected. As you can see in the table below, all the major players have a downward trajectory.

Hewlett Packard's (NYSE: HPQ) slide is not only triggered by a slowdown in PC business but also due to abysmal performance their printer segment. Microsoft (NASDAQ: MSFT) has saved face by spending billions of dollars on share buybacks. Intel (NASDAQ: INTC), the biggest semiconductor company in the world, has stabilized its earnings by driving growth from its Data Center segment.

All these stocks have taken a beating due to the "fall of the PC,' but Advanced Micro Devices (NYSE: AMD) has been hammered the most. The stock has lost nearly 70% of its value in 2012, falling from above $8 to below $2. This depreciation in stock price has been driven by falling sales and abysmal growth prospects of the entire industry.

The smartphones/tablet growth has seriously hurt semiconductor companies that have failed to make this transition from PC to handheld sourcing. Right now Qualcomm (QCOM) and NVidia (NVDA) dominate the handheld industry (smartphone and tablets), leaving very little room for new entrants.

HPQ data by YCharts

Figure 1: Price charts of major players in the PC industry

Valuations

AMD currently has approximately $1.15 billion in cash (accounting for wafer payments to Global Foundries in 4Q2012), which comes down to $1.6 per share. The primary trouble for AMD stems from the demand slowdown in its PC segment, which includes both Data Centers and PC, and the bad performance in Data Centers is due to AMDs’ inability to effectively compete with competitors such as Intel. The graphics segment of AMD is still doing well and is expected to show growth in 2013; it contributes approximately 25% to total revenues. If we use a P/S multiple of 1.9x for company’s graphics segment, we can value it at $4. While it might seem too optimistic, the recent inroads AMD has made into gaming consoles should not be discounted.

If we totally ignore the PC segment, the value of graphics and cash comes down to $5.6 per share; this is a major premium to current valuations. A major investor concern is the negative cash flows, which are eating away at the $1.15 billion cash hoard. The company expects to turn cash flow positive in the second half of 2013. If we take into account the recent focus on cost saving, the (limited) effect of Windows 8, and inroads into the gaming console industry, I believe AMD can achieve its target of becoming cash flow positive.  

Catalyst and investment strategy

As the chart below shows, the short interest has significantly declined in the last few weeks. This suggests that investors believe AMD has bottomed out. The next major catalyst for AMD's share price will be the January 22 earnings release. The stock price will move significantly over this earnings release because it will reflect the future of AMD’s PC business and substantiate the growth claims of graphics unit. These earnings will also reflect the success of Windows in reviving the PC business. Windows 8 was the last bet of PC industry in driving growth and, if this bet fails, the stock price of AMD will plummet once again.

 

Figure 2: AMD short interest, Schaeffer Finance

AMD is attractive at these valuations but remains a risky bet. Therefore I recommend investors to go in with covered calls. I would recommend that existing shareholders sell February calls with a strike price of $3, which will give investors a downside buffer on this risky investment (the premium received). The negative aspect of this strategy is the cap on upside potential, $3, which is still a 16% return at current price levels.


SmartEquity has no position in any stocks mentioned. The Motley Fool recommends Intel Corp. The Motley Fool owns shares of Intel Corp 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!

blog comments powered by Disqus

Compare Brokers

Fool Disclosure