AMD: Knee-Jerk Rally on AMD’s Earnings Warning Should Fade

By William Trent, CFA of Stock Market Beat

For all the people who complained about our bearish semiconductor outlook, saying things like “semiconductor companies can’t add new capacity instantly, so they spend their way through most downturns in preparations for the upswings. ’cause it’s always worked before,” perhaps this press release will provide some insight.

AMD (AMD) today announced it expects to report revenue of approximately $1.225 billion in the quarter ending March 31, 2007. Revenues declined sharply quarter-over-quarter for the Computing Solutions segment, primarily due to lower overall average selling prices and significantly lower unit sales, especially in the resale channel.

This was no small miss. Consensus estimates called for $1.55 billion in sales. To be off by 25% on the top line is pretty bad forecasting. Given that AMD was expected to lose $0.30 per share on the higher estimate (the release did not update EPS guidance), God only knows (management probably doesn’t) how bad the earnings will turn out.

We have been talking about the need for semiconductor managers to slow down their capacity expansions pretty much the entire 13 months Stock Market Beat has existed, and AMD has made a small move in that direction:

AMD will reduce 2007 capital expenditures by approximately $500 million, which the company believes will not materially impact capacity plans for the year.

It’s too late to do anything this year, so they are pushing back spending they had originally planned that would have added capacity next year. Doesn’t help anything for some time, but it is a start. It is bad news for equipment makers like Applied Materials (AMAT – Annual Report) and KLA-Tencor (KLAC).

As for AMD, the shares rallied on the news. Perhaps the initial reaction is that the steps they are taking will right the ship. However, we don’t see any fundamental support for the shares. Consider:

• The stock is expected to lose money this year and earn $0.33 next year (both of which are likely to come down, by the way). Even a 20x multiple on 2008 earnings would justify only a $6.60 price – and that is before the downward revisions that appear likely.
• The company has spent more money on capacity than it has generated in cash flow in each of the last three years. With negative free cash flow, how can a $9.3 billion enterprise value be supported? By our reckoning they would have to cut capital spending by another $1 billion this year to even begin to show the free cash flow needed to justify their valuation.

So we certainly aren’t buying into this rally.

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