Why This Company Is Losing the Microprocessors War

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On Oct. 18, Advanced Micro Devices announced its quarterly revenue rose 15% from last year's year-ago period, reaching $1.46 billion and beating the Street consensus.

However, shares fell almost 13% during intraday trading as investors realized AMD's outstanding revenue growth was just a one-quarter event. In the long run, AMD faces serious issues in the semiconductor industry. A declining PC industry, intense competition from R&D-focused Intel and the dominance of ARM Holdings  in the mobile semiconductors world leaves AMD with little market share left. How did AMD lose the war against Intel? More importantly, can AMD recover its business before running out of cash?

AMD Revenue TTM Chart

Source: YCharts

Chronicle of a death foretold
Intel has dominated the PC processor industry for decades. However, between  2001 and 2007, some of AMD's product offerings -- in particular, AMD's Opteron chip for x86 servers -- beat Intel's server chips in terms of performance. AMD's Opteron 144, released in 2005, was regarded as the best overclocker's CPU ever made. Makers of the fastest computer in the world in 2012, the Titan, chose AMD's Opteron CPU over Intel. 

Unfortunately, AMD's fate soon changed, as increasing pressure from a dying PC industry and competition from Intel hurt the company's margins. In 2007 and 2008, the company experienced huge losses. After 2008, business seemed to have recovered. However, in 2012, the company announced a loss of more than $1 billion.

Notice that AMD was never consistently profitable. Between 2003 and 2012, the company only generated positive free cash flow in 2009 and 2011. According to Forbes contributor Michael Kanellos, this happened because AMD did not believe in its people. A clear example is when AMD "politely showed the door" to Fred Weber, who was the man behind the development of Opteron. Instead, AMD prioritized Fusion, a chip designed to act as both a CPU and graphics accelerator. Fusion did not become a positive growth catalyst like Opteron. Its CPU performance and memory turned out to be weak, and it did not open new markets like Opteron did. Aware of Fusion's weaknesses, Intel took that opportunity to regain market share in the server space.

 Intel's expansion in the server and PC markets allowed the company to gain more scale advantages. AMD, on the other hand, does not enjoy economies of scale. In 2012, the company reported an operating margin of -19.5%, while Intel enjoyed a positive 27.4% . Furthermore, from 2003-2012, Intel never generated negative cash flow, but instead accumulated more than $19 billion in cash and short term investments, which will likely be used in the future to support strategic investments or be returned to shareholders. AMD, on the other hand, is left with $1.2 billion in cash, only $100 million above the company's target. Unlike Intel, AMD has never paid dividends.

To make matters worse, while AMD and Intel were fighting a price war for the PC segment, ARM Holdings saw an opportunity in developing semiconductors for tablets and smartphones. In a few years, the company mastered the design of low-power processors. Interested only in the high-margin designing part of the business, ARM decided to leave manufacturing to its clients, and instead focused on selling its technology using licenses.

This strategy allowed the company to focus its capital expenses only on research, avoid huge manufacturing costs, and expand very quickly. ARM designs are now used in more than 95% of the world's mobile phones. Likewise, ARM's efficient business model helps to keep profit margins high. Last year, ARM's operating margin was 36.1%, almost 10 percentage points above Intel. Due to its IP-based model, ARM's revenue last year was just over $1 billion -- less than what AMD makes in a quarter. However, ARM was able to transform 22% of its revenue to free cash flow, while AMD experienced negative cash flows of $471 million last year.

Despite missing the smartphone revolution and losing server and PC market share against Intel, AMD can still recover. There's an ongoing restructuring plan, and management appears to be less focused on fighting Intel in the PC market. The company's attention is now on high-growth segments. The company is working to develop energy-efficient microservers and it will continue investing in its Kabini and Temash chips, which were developed for tablets and consoles. 

Naturally, AMD isn't the only company in search of lost time. Intel is about to launch its low-cost Haswell and Bay Trail-M chips in an attempt to capture smartphone, console, and tablet manufacturer market share from ARM. Unlike AMD, Intel isn't "barely profitable" and can commit more money to research. Competition will be fierce, so instead of targeting each promising market segment, AMD may do better if it narrows its focus. 

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The article Why This Company Is Losing the Microprocessors War originally appeared on Fool.com.

Adrian Campos has no position in any stocks mentioned. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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