The ‘Zen’ reason to bet now on mercurial AMD.
It’s tough to be contrarian on a stock that’s up 638% in the past 12 months.
But despite these big gains in the shares of Advanced Micro Devices AMD, -1.70%this mercurial chip maker checks off one contrarian box in spades.
Well more than half of Wall Street sell-side analysts still have a “sell” or a “hold” rating on the stock, notes AMD bull Brian Smoluch, who helps manage the Hood River Small Cap Growth Fund HRSRX, +0.17% .
He’s looking for even more gains ahead. Call him greedy if you want. But I’d give Smoluch some credence. His fund beats competitors by 4 percentage points, annualized, over the past five years, according to Morningstar. At a time when most managed funds lag the market, this record stands out.
Hood River did recently trim its AMD position ever so slightly, according to filings at the end of January. But AMD was still the fund’s top holding, representing 4% of the portfolio. That’s a significant outsize bet in the conservative land of mutual funds, where managers often strive to stay with the pack by limiting position size to around 2% or less to reduce single stock risk.
Why is Smoluch putting so many chips on AMD’s chips?
It’s all about Zen. Not the psychological state of Zen Smoluch needs to stay with a concentrated position in such a highflier. Rather, the Zen line of chips that AMD is about to roll out.
Advanced Micro Devices’ current “Bulldozer” chip architecture never really did much for shareholders. It got a lot of hype, and it led to an AMD recommendation in my stock newsletter in March 2011 at $9. Then the stock got bulldozed. By the start of 2016 AMD shares had fallen 77% to $2. Anyone who held throughout is now up 50%, given that the stock is more than a five-bagger since early 2016, crushing the S&P 500 SPX, +0.40% , which has climbed 17% since then. Admittedly, though, it’s pretty tough to stick out a 77% stock loss, unless you have Warren Buffett’s long-term perspective and nerves of steel.
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AMD bulls now look for even more gains thanks to a major chip rollout starting in March, which should continue with several hits throughout 2017.
Here’s some background: Over the last two years, AMD’s chief competitor, IntelINTC, +0.36% slowed down the rate at which it was pushing chip technology. That left an opening for AMD to cook up the Zen chip and catch up. AMD’s Zen chip architecture fixes Bulldozer with a 40% improvement in clock speeds, a key measure of how fast chips function.
“They have a new architecture that is starting to ramp right now that should put them at a competitive level with Intel, which they have not had for years,” says Smoluch.
The potential here looks particularly promising because AMD has such small market share. Its market share has been beaten down to 1% or less, depending on the type of chip and end-market product they’re in. “There is so much headroom for them in terms of market share,” says Peter Karazeris, a tech analyst with Thrivent Financial. “Basically they just need their products to get any acceptance at all, and they will do well.”
How much business can they take? The main market to watch is servers. “We don’t think it’s unreasonable for them to get to 10% share if the technology works well. And we think it does,” says Smoluch. He cites potential customers who have tried test versions of Zen chips and confirmed that they’re great.
Leaked performance tests of new AMD graphic processor units (GPUs) also support this conclusion, says Morgan Stanley analyst Joseph Moore.
Bulls also expect AMD to take back significant market share in PCs and laptops.
AMD’s new chips will sell at much higher margins than the more commoditized chips it now sells for game boxes and other devices — its current meat and potatoes business. “There is a lot of operating leverage in the business if they get it right,” says Smoluch.
Sources of demand
Tech-sector experts cite two reasons why there’s a hunger for an Intel chip competitor among companies that buy lots of servers or chips to put in servers they make, like Alphabet GOOG, +0.15% GOOGL, +0.13% Facbook FB, +0.08% AmazonAMZN, -0.02% Microsoft MSFT, +0.37% Yahoo YHOO, -0.97% and AkamaiAKAM, -0.08% and hardware suppliers like HP HPQ, +0.12% Dell, Lenovo and Alphabet.
First, no one ever wants to be dependent on one supplier. “If you are a manufacturer, you don’t want to be beholden to one company,” says Tom Vandeventer, portfolio manager of the Tocqueville Opportunity FundTOPPX, +1.20%
Second, AMD will price its chips lower, and this will offer an opportunity for companies like Alphabet, Facbook and Amazon to reduce costs. “One of their biggest costs is the gross margin they pay to Intel for Xeon processors,” says Rohan Kumar, an analyst with Hood River Small Cap Growth Fund. AMD will help these companies “cut one of their big cost centers, and they haven’t been able to do that for 10 years,” he says. He estimates that AMD’s 14 nm chips will cost about 15% less than 14 nm chips from Intel.
Consumers will be able to save money, too. PCs and laptops sold at retailers like Best Buy BBY, +3.00% will probably cost about 10%-15% less with AMD without much performance loss.
Here’s a sweetener for investors: AMD has been such a train wreck for the past several years that it has about $6 billion in net operating losses to shield profits from taxes.
A few serious challenges
So why is half the sell side negative on AMD?
The biggest problem: AMD doesn’t have the research and development budget commanded by competitors Intel and Nvidia NVDA, +0.52% . “We see it as unlikely that a company spending 8% of Intel and Nvidia’s combined R&D budget is going to continue to thrive over the long haul,” says Morgan Stanley’s Moore.
Read: Michael Brush says Nvidia’s stock can beat the broader market for years to come
Near term, this suggests AMD may have trouble keeping up as Intel continues to push the limits of technology to move further down the path of “die shrink” in chip production. Indeed, Intel will best AMD later this year.
The most advanced chip manufacturing now uses 14-nanometer (nm) production. A nanometer is a billionth of a meter, and “14 nm” refers to the distance between components or nodes on a chip. Reducing this distance is a major R&D challenge, but it’s what allows chips to keep getting faster.
Intel introduced its 14-nm technology in 2014. But then it surprised investors in 2015 by announcing it would delay transition to the next level, 10 nm, by about a year, to later this year. That gave AMD the opportunity to catch up with 14-nm production — which it did with the Zen chip.
“Intel left a hole for AMD to exploit, and AMD appears to be exploiting it nicely. But historically these windows do not last forever,” cautions Morgan Stanley’s Moore.
Indeed, Intel should begin closing the window in the second half of this year when it releases its first 10 nm chips, called Cannonlake. “Nobody should doubt Intel’s superiority when it comes to process technology for microprocessors,” says Moore. “We think the opportunity for Zen is unlikely to grow meaningfully in 2018.”
Intel has a lot of motivation to defend its market share. Its growth has been weak. Excluding gains from the acquisition of chip maker Altera, Intel’s revenue has only grown by $2 billion, to $58 billion, since 2011, notes Moore, or less than 1% annualized. “Intel is going to put up a fight,” he says.
AMD bulls think their favorite chip maker will keep up. Smoluch believes AMD could match Intel with 10-nm production next year or just leapfrog down to 7 nm. AMD CEO Lisa Su is already talking about Zen II and Zen III — to keep pace with Intel, and more. “We are actually in the process of developing now in 7 nm,” she said in the company’s fourth-quarter conference call. “We think the 7-nm foundry road maps that are available are very competitive and will ensure that we have a strong multigenerational road map.”
That remains to be seen. But to buy AMD shares now, you have to believe that she’s right. Meanwhile, here’s a more concrete road map — the list of AMD’s Zen products due out this year.
A desktop version of this high-performance, Zen-based central processing unit (CPU) is supposed to ship in early March. The sever version will come out in the second quarter. Ryzen notebook processors will ship in the second half. You can expect sales of chips for consumer-oriented products like laptops and PCs to ramp faster than Ryzen chips for servers used by businesses, says AMD.
AMD’s Polaris GPU has been holding its own among gamers. But the Zen-based Vega line of GPUs due out in the second quarter promises to make more serious inroads on business at Nvidia, the category killer. “The expectation is that they can claw some share back from Nvidia,” says Vandeventer.
As a GPU, Vega will also power computer systems used in high-end design, advanced data analytics, and machine learning.
Designed for use in servers, this CPU will launch in the second quarter. Though it’s a high-end chip, AMD CEO Su describes it as a “general purpose product” suitable for use across several applications, from big data analytics, cloud computing, and storage, to communications and more traditional day-to-day apps deployed by companies.
At the time of publication, Michael Brush, a Manhattan-based financial writer, had no positions in any stocks mentioned in this column. He has suggested AMD, AMZN, FB, GOOGL and AKAM in his stock newsletter Brush Up on Stocks.