We still believe in AMD's future potential, but near-term results make it difficult to see

Published Tue, Nov 1 20228:17 PM EDT

Advanced Micro Devices (AMD) reported fiscal third-quarter results that missed lowered expectations on after the closing bell Tuesday. The stock initially dropped in after-hours trading before reversing and rising 4% as investors took solace in AMD's year-over-year revenue advance in Q3. Unfortunately, we don't see much in the report to indicate any let-up in the near-term of the troubles facing the semiconductor industry. Revenue in AMD's third-quarter increased 29% to $5.57 billion, missing estimates of $5.62 billion. Adjusted gross margin expanded 150 basis points to 50%, largely in line with expectations. Adjusted earnings per share fell 8% to 67 cents, missing analyst expectations of 68 cents. Bottom line There were no major surprises as management preannounced the quarter in early October. Given that the issues plaguing the industry are well-understood at this point — primarily weak personal computer demand and U.S. export restrictions on certain high-end chips to China — investors appear to have been managing their expectations and forgiving AMD's slightly weaker than expected guidance, which again was tempered due to weak PC and video gaming demand. While AMD has been taking advantage of consistent missteps at Intel (INTC), management is executing effectively on their stated roadmap and appear to be effectively navigating the difficult operating environment. Data center revenue remains resilient thanks to strong North American cloud demand, where AMD is strongest, while Embedded segment sales benefited from strong end market demand. Gaming and Client will remain weak into year end, but AMD is taking its medicine and working diligently to clear out elevated inventory levels by the end of the year. That's set the company up in a better position heading into 2023. While the long-term drivers of growth — cloud computing, gaming, and digitization — appear fully intact, the near-term issues must be resolved. Channel inventories must flush out. We need more clarity on the macroeconomic front as it is causing enterprise customers to understandably slow the pace of spending. That's similar to what we heard from fellow Club holdings Microsoft (MSFT) and Amazon (AMZN) about their cloud demand, when they reported their quarters last week. Unfortunately, we will need to get through these more immediate issues before investors can even start thinking about those future growth drivers, let alone leaning on them as a reason to buy shares. Given that (1) the inventory glut appears ready to last at least through year end, (2) enterprise spending will depend on gaining economic clarity, and (3) the state of semiconductor sales into China remains in question, we are reducing our price target on AMD shares to $85 from $130. We're maintaining our 2 rating despite the relatively attractive valuation, even after accounting for the fact that analysts are no doubt going to take down 2023 estimates Wednesday. However, there's simply no reason to prioritize the semiconductor sector as a place to commit additional funds in this environment. For the Club portfolio, we've been scaling back our chip exposure in pockets of strength over the past few weeks. We also encourage members to take a look at our guide to the semiconductor industry that we published earlier Tuesday. We think this knowledge will help make better sense of the quarter and drivers of AMD's long-term growth and how the chip industry works. Q3 companywide results As a reminder, AMD reports results through four segments: (1) Data Center, which includes server central processing units (CPUs), data center graphics processing units (GPUs), Pensando and Xilinx data center products; (2) Client, which is desktop and notebook PC processors and chipsets; (3) Gaming, which is discrete graphics processors and semi-custom game console products that go into Microsoft 's (MSFT) Xbox and Sony's PlayStation); and (4) the Embedded segment, which includes AMD and Xilinx embedded products. Data Center revenue increased 45% to $1.6 billion, in line with expectations and marking the 10 th straight quarter of record server processor sales thanks to strong sales of EPYC server processors. Operating income in the segment was $505 million, representing 31% of revenue. That's up from $308 million and 28% of revenue, one year ago. While enterprise OEM (original equipment manufacturer) revenue was down sequentially as customers slowed purchases due to macroeconomic uncertainty, cloud was up sequentially and more than doubled versus the year ago period. Driving the segment, management said that the EPYC generation 3 is the highest performing and most energy efficient server CPU in the market today, and the team expects to further extend that lead next week with the public launch of their generation 4. That's a 5 nanometer EPYC CPU, which is expected to deliver significant performance enhancements and increased energy efficiency. Energy efficiency is of particular note given that both Microsoft and Amazon called out increased energy costs weighing on cloud segment margins. Outside of CPUs, management called out record sales of Xilinx FPGA and network Data Center products and said, "The addition of Pensando DPUs [data processing units] to our product portfolio has been very well received by customers highlighted by our Enterprise customer pipeline doubling in the few months since the acquisition closed." With AMD now in position to address more customer data center needs than ever before thanks to past acquisitions of Xilinx and Pensando, management expects long-term growth and market share gains to continue. Client revenue was $1 billion, a decrease of 40% year over year, however, on par with consensus estimates. Sales were hurt by weak PC demand and a focus channel partners on reducing inventory, which resulted in AMD shipping below consumption. Essentially, AMD is shipping below consumer demand in order to help resellers clear out their inventory. Operating losses came in at $26 million, down from income of $490 million in the year ago period. Gaming revenue was $1.6 billion, up 14% year over year and also in line with estimates driven by higher semi-custom product sales. It was partially offset by a decline in gaming graphics revenue. This marks the sixth straight quarter of record semi-custom sales thanks to resilient demand for next-gen gaming consoles — PlayStation 5 and Xbox Series X|S — ahead of the holiday season. Gaming graphics took a hit due to soft consumer demand and management's efforts to reduce channel inventory ahead of the next-gen GPU launch later this week. Operating income in the segment was $142 million, representing 9% of revenue. That's down from $231 million and 16% of revenue, one year ago. Embedded revenue were up significantly year over year at a record $1.3 billion, also in line with expectations. Growth was primarily driven by the inclusion of Xilinx's business. On the call, management called out record sales to aerospace and defense, automotive, and communications customers. Operating income in the segment was $635 million, representing 49% of revenue. That's up from $23 million and 30% of revenue, one year ago, with