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Advanced Micro Devices, Inc. (AMD) Pulls out of its Nose Dive

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Advanced Micro Devices, Inc. (NYSE:AMD)The long, steep decline in revenue of Advanced Micro Devices, Inc. (NYSE:AMD) has finally come to an end, thanks to the start of processor deliveries for the new Microsoft Corporation (NASDAQ:MSFT) and Sony Corporation (ADR) (NYSE:SNE) game consoles.  Ramp up of production of the custom game console processors can be expected to return AMD to profitability in Q3. The question for investors now becomes, is this profitability sustainable?

Pulling out of the dive

As the chart below shows, Advanced Micro Devices, Inc. (NYSE:AMD) has, at least for now, pulled out of the revenue nose dive that its Computing Solutions division has suffered since the beginning of 2012.

The question of sustainability was evidently on the minds of AMD investors as they mulled over Advanced Micro Devices, Inc. (NYSE:AMD)’s Q2 earnings report on 7/18 during after hours trading. AMD shares had closed up nearly 6% only to give most of it back after the markets closed.

If there was a single specific catalyst for the change in sentiment, it must have been a question by an analyst asking whether the new revenue from console APUs (Accelerated Processing Units in AMD-speak) would only just offset the loss of royalties from the previous console generation.  It was as if all the air had been suddenly sucked out of the room, leaving the Advanced Micro Devices, Inc. (NYSE:AMD) execs gasping for breath.

In fact the revenue streams do not work out to be comparable, even if you assume the low end of the unit shipments for console APU’s of 5 million per quarter, which agrees with the historical average for combined console shipments by Microsoft Corporation (NASDAQ:MSFT) and Sony Corporation (ADR) (NYSE:SNE) since the introductions of their current generation consoles. The analyst had estimated that AMD made about $100-150 million in royalties per year. At 5 million console APU shipments per quarter, a $40 ASP, and assuming 35% gross margin, the gross profit per quarter works out to be about $70 million, for an annual gross profit almost double the assumed royalties.

But the question took away the celebratory air of the conference call, and left unanswered whether Advanced Micro Devices, Inc. (NYSE:AMD) could sustain profitability after Q3.

A closer look at AMD’s Q3 guidance

On the surface, Advanced Micro Devices, Inc. (NYSE:AMD)’s guidance for Q3 was refreshingly positive: a sequential increase of 22% in total revenue to $1.4 billion, a reduction of operating expenses to $450 million, and a gross margin of 36%. Turning the crank on the numbers yields an operating profit of $59 million. Not great, since it won’t even represent an improvement over AMD’s 2012 Q3 results ($1.269 billion in revenue, operating income of $131 million), but much better than the recent string of losses.

Most of the $260 million increase in revenue for Q3 will necessarily come from console APU shipments. Revenue from the graphics division will probably show negligible growth, hovering around the $320 million mark. There are signs that Advanced Micro Devices, Inc. (NYSE:AMD)’s share of the PC and server processor market has stabilized at about 15%, but growth is doubtful.  As I discussed in my recent post on Intel Corporation (NASDAQ:INTC)’s Q2 earnings, in Q3 Intel will roll out fanless dual core Haswell processors, and in Q4 the Bay Trail Atoms arrive for thin and light tablets. Both processor families use Intel Corporation (NASDAQ:INTC)’s latest 22 nm process, which provides an inherent energy efficiency advantage compared to the 32-28 nm processes used by AMD’s foundry partners.

This leaves console APUs with the burden of carrying the full $260 million increase. By virtue of the revenue generated by the Computing Solutions division in Q2, it’s clear that Advanced Micro Devices, Inc. (NYSE:AMD) has already shipped a substantial number, about 5.5 million console APUs. They would need to in order to support planned build ups by Sony and Microsoft for the holiday season, which have to be started months in advance of shipments to retailers. In order to reach the target revenue of $1.1 billion for Computing Solutions, AMD will need to ship about 12 million console APUs in Q3.

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