Time to Sell AMD Stock? What You Need to Know

By Rich Smith Markets Fool.com

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Continue Reading Below

Shares of semiconductor giant Advanced Micro Devices (NASDAQ: AMD) are in free fall this morning, knocked for a loop by a giant sell rating from Wall Street's Goldman Sachs. After closing at $14.17 on Wednesday, the stock fell as far as $12.83 in early Thursday trading -- so the "good" news here is that it's now down only 7%.

Here are three things you need to know about why.

Goldman Sachs' sell rating shocked AMD investors this morning. Image source: Getty Images.

1. What Goldman Sachs said

Completely out of the blue, Goldman Sachs initiatedAMD stock with a sell rating and an $11-per-share price target this morning. If the analyst is right about that, it means AMD investors stand to lose 22% in market capitalization on their AMD shares over the course of the next year.

Continue Reading Below

Already, the stock is down 7% in response to Goldman's rating, suggesting worried investors are taking the analyst's warning to heart -- and don't want to stick around for more losses. But are those fears justified? Isn't Goldman's sell rating just one opinion in a sea of opinions about AMD?

2. Why Goldman Sachs said it

At its heart, Goldman Sachs' sell rating is a valuation argument. Investors are betting on a big improvement in AMD's business as consumers warm to its line of Ryzen microprocessors, and they like its growing prospects in PC gaming, artificial intelligence, and computer deep learning. Many analysts who follow the stock believe that AMD will enjoy rapidly rising revenue(and profits) over the coming years.

On average, analysts quoted on S&P Global Market Intelligence are calling for AMD's revenue to grow nearly 50% over the next four years -- and for operating profits to grow 16-fold. But as explained in a write-up on TheFly.com this morning, Goldman believes the potential improvement in fundamentals has already been priced into the shares. As a result, while some appreciation in stock price may have been justified, now that the stock is up nearly five times in two years, the current risk-return profile is unfavorable.

3. Anatomy of a sell rating

Priced today at nearly 44 times next year's profits (i.e., profits AMD is not even guaranteed to earn), Goldman sees AMD's current stock price as "difficult to justify."

Most analysts on Wall Street expect to see AMD turn profitable as soon as next year (earning a GAAP $0.11 per share, and $0.25 pro forma). Goldman, however, warns that that's a "very bullish" view -- and likely not to be correct given pricing pressure from even larger semiconductor powerhouses Intel (NASDAQ: INTC) and NVIDIA (NASDAQ: NVDA).

Goldman's best guess? NVIDIA will earn only $0.14 per share pro formanext year, which implies an actual, GAAP profit of zero dollars, zero cents.

What it means to investors

And Goldman Sachs' argument makes sense. As the analyst explains it, there's certainly a possibility that AMD will succeed in winning market share this year with its powerful Ryzen chips. But even if it does succeed, then Intel and NVIDIA would probably try to lead customers back to the fold by offering price concessions on their own chips.

The result would be short-term revenue gains for AMD, followed by margin compression on that revenue later in 2017 and heading into 2018 as the company is forced to cut its own prices to fend off competition from Intel and NVIDIA. So what would that portend for AMD investors?

According to S&P Global data, AMD hasn't succeeded in posting a full-year profit since 2011, a year in which its operating profit margin surpassed 7%. Currently, that margin is coming in just shy of negative 9%. So while it's possible it will improve for a quarter or two, the end result of the moves AMD's rivals would make to counteract its gains in market share would likely plunge AMD's profit margin right back into a bath of red ink -- and deny the company the ability to report a profit in 2018.

Investors betting on a return to GAAP profitability at AMD may have to wait a bit longer to see it.

10 stocks we like better than Advanced Micro Devices
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Advanced Micro Devices wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of April 3, 2017

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Nvidia. The Motley Fool recommends Intel. The Motley Fool has a disclosure policy.