AMD's Gamble: Stronger Earnings on Weaker Margins

After Intel’s introduction last July of its Core 2 Duo processor series, which tests showed performed far more strongly than anything else that company had produced to date, AMD took the risk it had to take: It dropped prices by almost 50% on all but its highest performing processors (the Athlon FX series). The market took note immediately and demand rose substantially, as AMD acknowledged in its third quarter 2006 report yesterday.

But financial analysts didn’t see that wave coming –- or, more accurately, that it had already come last summer -– until after the exchanges closed yesterday. While AMD’s net sales rose by 9.1% over the third quarter of 2005, from $1.21 billion to $1.32 billion, gross margin took a negative turn, down 5.4% to 51.4%.

This reflects two factors: First, the cost of sales is rising –- it costs AMD more money now than it did before to sell processors -– and the company cutting prices for its CPUs.

During yesterday’s third quarter report, AMD executives spent some of their time apologizing for the good news. AMD’s move may have helped it retain market share in the face of the strongest competitive offering from Intel it may have ever faced, although the raw numbers have yet to be tabulated.

Prior to Intel’s summer release, independent estimates had given AMD the edge in market share over Intel in the consumer PC markets, with strong gains in the mobile arena, as well as AMD’s first serious inroads in server processors. For years, AMD always had the edge in “value” processors at the low end, where the company first made its name.

But low-end processors are associated with low margin sales, so when AMD’s margins head back down, financial analysts become worried that the company is retreating back to the safety of its roots. For it to continue making inroads with its Opteron processors in the server arena, AMD has to keep on making solid gains in performance.

As AMD has indicated to BetaNews, its next opportunity for such gains may come next month. In the meantime, though, it has to explain away a quarter where it let margins slip to avoid worse setbacks.

To put this margin slip in a little more perspective: AMD’s gross margin for the third quarter of last year was 41.1% (only when you exclude the memory products segment from the tally does Q3 2005 gross margin actually come out to be 55.4%, as one AMD statement reads this morning). So margins have been improving over the past several quarters, until the one just ended, which represents a U-turn.

Meanwhile, Intel gross margins have been stuck in neutral, currently at 49.1% with a forecast for around 50% for the final quarter of this year.

AMD CEO Hector Ruiz admitted to analysts on yesterday’s call that his company failed to accurately gauge the increasing demand for notebook processors worldwide, and that it may not have planned for the proper “mix” of CPU offerings. This is a puzzling comment, especially from a company that continues to predicate its reasons for acquiring graphics chip producer ATI on apparently high customer demand for a comprehensive chipset platform for portable systems.

Net income for AMD rose briskly, up 51% over the year-ago quarter to $134.4 million. And earnings per share rose to 28 cents per share from 18 cents in Q3 2005, rounding off the news of near-term payoffs.

So this morning’s worries are about AMD’s long-term outlook, which include skepticism that its upcoming “4x4” platform offering and new Athlon 64 X2 processors may not help it regain the price/performance advantage on the high end. AMD shares traded in the late morning down as much as 10% on the New York exchange, on heavy volume.